Bubbles….what are they and why can the Fed not see them?

In a previous post:

I commented on Janet Yellen’s putdown of suggestions of excess usually associated with the term “bubble” and graphically demonstrated that there existed a significant divergence between US economic/income growth and asset values (debt/equity) that would suggest a bubble of sizeable proportions existed. 

I also provided a link to a prior post on bubbles that mentioned per se that the very fact that asset values tended to discount the future, in a monetary system, meant that bubbles were in fact a de facto natural component of a monetary driven economic paradigm.  The key issue was the balance and the relationship between the two, itself a function of the nature and balance of fundamental economic relationships and their emergent properties.   A great many of my previous posts assert the existence of a perilous divergence and describes the many imbalances that have accentuated this imbalance and which have added to its instability.  

When we talk of bubbles in the same frame as bursting and collapse what we are talking about are unsustainable relationships that are being pushed to their extremes and beyond.   We are talking about divergence in the order of things, about structures whose natural relationships are being pushed so far out of alignment that minor shocks produce extreme outcomes..  This is where the statistician’s fat tail comes in and once we realise that we have an imbalance it is no longer a fat tail but a much higher probability outcome.

A bubble may burst in the sense that the growth of the energy in the system exceeds its structural ability to continue to expand at a rate consistent with the change in energy.   This could be seen as inflation in the economy or as inflation in an asset price as demand for that asset outstripped its value and the ability to supply that demand.  Bubbles in this context can lead to misallocation of resources as noted in a recent BIS report on this issue.  

A bubble can also deflate in the sense that the energy driving the fundamental drivers of growth in the system either no longer require the frame to expand at the same rate or, indeed, that the financial frame needs to scale backwards to accommodate the decline in system energy (this would be the case where demographics are slowing and are in decline and where productivity growth has slowed and also where distribution of income is impaired). 

If monetary and fiscal decision makers view the gear change in growth as a temporary aberration and attempt to force expansion of either/or both the fundamentals and the financial frame, when in fact the frame is naturally contracting (depreciating) or its growth rate slowing, then we risk divergence between the fundamental drivers of the system and the frame.  In other words the energy added to the system complicates the much needed adjustment of the  frame as stimulus temporarily expands both, and in the current case, expands the financial frame at a growth rate well in excess of the fundamentals whose own trajectory has been temporarily amended.

In other words where we have had slowing demographics, transitory economics and monetary stimulus as well as increasingly skewed distributions of national income.  We have had a de facto bubble developing and this has manifested itself in ever higher levels of debt and asset focussed money supply growth at the same time as productivity/demographic/CAPEX/economic/income growth have decelerated.  But either the Fed cannot see or, perhaps like many regulators, it does not feel that righting bubbles is its mandate.  All the same the extremely narrow focus on system dynamics is a disturbing one that has more than likely been a major vitiating factor in the development of current imbalances.

US debt/asset dynamics……the bubble the Fed appears not to see

In last week’s “Decision Making at the Federal Reserve” at the International House of New York Janet Yellen said that the US economy had made tremendous progress in recovering from the damage caused by the financial crisis, that labour markets were healing and that the economy was on a solid course.  She also said the economy was not a bubble economy, and that if you were to look for evidence of financial instability brewing you would not find it in key areas: over valued asset prices, high leverage and rapid credit growth.  She and the FRB did not see those imbalances and despite weak growth would not describe what we currently see in the US as a bubble economy.

Perhaps the question was the wrong one.   The bubble, indeed most bubbles, are financial in nature and relate to both the flow of financing and the current stock of financing.   We are always in a bubble to some extent given that one of the key facets of the monetary system is the discounting of the present value of future flows through the allocation of assets, principally of money relative to all other assets.  Today’s differential between what the economy can produce over time and the value and supply of assets that represent the future expenditure flows from our economy, are I believe, in excess of the present value of those flows.  Part of this is due to monetary stimulus designed to drive growth forward in the face of demographic change, increasing income inequality (which weakens the expenditure base of the economy) and important transitions in key emerging economies that have numerous structural relationships.

We are in a bubble and while the economic issue today is one of a deflating frame (i.e. not one with inflationary characteristic usually associated with economic overheating), the differential between the financial frame and the economic has arguably never been so wide.  Perhaps the Federal Reserve should have defined what they believed to be a bubble or rather the moderator should have been a bit cleverer! 

Some may say that excess financial leverage of households has moved back to more sensible levels:  the following chart shows that consumer debt levels have moved back to early 2004 levels but that these levels were associated with much higher longer term real GDp growth rates.  In this context debt has not really fully adjusted.

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And, looking at shorter term real growth trends we see that real GDP growth has peaked at much lower levels relative not just to total debt to the rate of increase in consumer debt.  One would be forgiven for thinking that the last 5 years included a recession in the data, but it has not:

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Correlations, volatilities and expected returns as the monetary tide reverses flow..

I note comments by El-Erian over Central Bank’s inability to suppress volatility as a bigger risk than China and I would agree although I would qualify this in terms of the immediate asset price risk.   Asset focussed money supply growth and asset price relatives (relative to GDP growth and income growth as well as its distribution) are all deeply negative for asset markets when liquidity dynamics, amongst others, change.

Recent commentary by Zero Hedge on the winding up of Nevsky Capital is also worth reading: the Nevsky Capital report suggested that a disciplined structure can no longer be counted on to realistically manage risk and return given the uncertainty of an increasingly skewed distribution of possible outcomes in an environment worryingly distanced from fundamentals/exposed to unconventional monetary policy; liquidity dynamics in the market place also impacted.  

Another interesting piece of data shows the 10 year rolling returns on commodities that I found in a tweet from @zatapatique.

I have written on the issues of excess asset focused money supply and liquidity for some time (relevant posts of mine).

Many portfolio management structures depend on expected return/correlation/standard deviation assumptions that would be very much exposed to a break in the direction of money flows towards assets.  All statistical measures of risk and co variance are drawn from the impact of monetary demand flows for assets.  In an environment where monetary policy is accentuating flows to asset classes as well as expanding the quantity of money and reducing the supply of certain asset classes the natural flow response to risk and return in the environment are muted.  As unconventional monetary policy recedes, additions to the quantity of asset focussed money and interest rate support reverses, the natural flows not only start to reassert but the prior excess flows adjust to the new environment.  We get a break out of trading ranges and covariances.

This is all incredibly risk and uncertain for those dependent on traditional statistical measures of asset price sensitivities and covariances.

Why do economists like Paul Krugman completely ignore financial imbalances and their structural accentuators?

In a recent post Paul Krugman challenged the “rationale” for the Minneapolis Fed appointment of Neel Kashkari.

His objection lay with “the view” of the new chair (Kashkari) that growth prior to the breaking of the financial crisis was artificially fast due to the leveraging of the economy.  Krugman’s point was that just “because we had a bubble, in which some people were borrowing too much,” does not mean that the output produced from 2000 to 2007 wasn’t real and therefore the problem we have now is 100% one of insufficient demand as opposed to supply. 

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A brief “thought” on debt defaults, asset prices, MS velocity and consumption expenditure risks.

When a private non bank debt collapses the money supply itself is not impacted.  There is however a collateral impact on future expenditure and the velocity of money supply itself.

Asset values are extremely sensitive to portfolio cash allocations.  A given reduction in preferred cash holdings relative to other assets, all other things equal, raises asset prices by a much greater magnitude and vice versa. 

However not all transactions represent closed loops: a disposal of an asset for future consumption transfers asset focussed money supply to consumption focussed money supply.  With money also being transferred in to the asset portfolio the net impact on asset values of consumption related transactions tends to be much smaller.

A default in non bank debt, or loss of any asset, should therefore have an impact on future MS velocity and expenditure while also possibly increasing the asset focus of money supply (all else being equal).  In the event of default, assets/collateral are no longer available for sale in exchange for money for consumption expenditure purposes (and of course investment expenditure purposes) and the potential velocity of money supply falls, specifically with respect to consumption and possibly also with respect to assets. 

Likewise a fall in asset values, especially the significant declines seen in recent decades, also impacts expenditure and MS consumption focussed velocity. Typically asset price declines have been short lived and given the fact that marginal transfers out of the global asset portfolio for consumption purposes has tended to be small in % terms, the impact of price declines etc on expenditure has also historically been small – this is especially so where asset focussed money supply growth has been expanding, demand for assets have been expanding (+ve population growth and demographic dynamics), where there is increasing income inequality (less MS flows out of the asset portfolio etc), but much less so in the reverse scenario.  

QE on the other hand has tended to focus primarily on supporting the financial system and high quality assets with minimal risk of default.   Whether it impacts expenditure decisions depends on the liability profiles of asset holders in general.  In a world of increasing income and wealth inequality asset price support may have only declining marginal benefits for consumption expenditure even though the resulting increase in asset focussed MS has affected a much wider range of asset prices. 

QE and low interest rate policy may well have supported potential expenditure based relationship loops from assets to consumption via asset price support based solely on asset valuations (not re yields) but may also, via increased risk taking within the higher yield/shadow banking asset spectrum, have increased the consumption sensitivity of assets; higher yielding assets are likely to be more consumption sensitive than lower yielding equity type assets.  

QE and lower IRs may well have increased the exposure of consumption and possibly also investment expenditure to future asset price shocks via two routes:

Increased exposure to leveraged loans, emerging market debt, high yield bonds, collateralised debt/loan investments, “wealth management products” (China) etc, exposes future consumption expenditure to higher default based risks, especially in high debt/low growth environments.  This depends on the extent to which QE has pushed investors out of lower risk higher yielding assets into higher risk/relatively higher yielding assets and the changing composition of the market portfolio especially with respect to those investors exposed to higher future liability demands.

Higher asset prices in low growth environments with increasing debt to GDP ratios also exposes consumption and investment expenditure to greater asset price volatility: we have seen quite extreme fluctuations in asset prices since the late 1990s.  As populations age the sensitivity of expenditure to asset prices increase.

The issue of default and asset price shock is compounded by issues of liquidity, especially with regard to many shadow banking products that investors may confuse as being cash like and therefore exposed to greater liquidity risks in risk events.

It is probable given the higher debt to GDP ratios, slower growth profiles and the many transition risks in the global economy, that global asset price consumption risks are not insignificant.  Another reason to support asset prices, another reason for QE and negative IRs, but not necessarily a solution.

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I am not a fan of outsized monetary accommodation in a declining growth frame…but what can you do?

Irrespective, deflation is not the issue, but slowing growth within a complex frame over burdened with financial excess and key structural imbalances. 

A recent speech by Andy Haldane has kept the interest rate/zero lower bound debate “bubbling”.   In this speech, “How Low Can You Go”, Haldane broached the issue of monetary policy in the event of another demand shock.  He is quite right to do so since monetary policy would have little room for manoeuvre with interest rates only a scuff mark away from 0%.  His musings suggested getting rid of cash and bringing in negative rates.

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China rebalancing, a crisis? Yes, and one of magnitude and complexity.

China did not end up with its current imbalances as part of a natural process and therefore the transition itself is unlikely to be natural. 

China is both the here and now and the future, it has untold potential, a growing debt problem (here, here, here, here, here and more in the links below) and a “government” still “seemingly” capable of pissing great distances into the wind.  But working out China for many is tougher than working out the meaning of life itself.

I have concerns over the ease and the speed with which many believe China can rebalance itself from an export led/debt financed investment growth model to a debt financed services and consumption growth led model.  That is how China can transform itself from a manufacturer of goods to the world and builder of infrastructure, to a perfect model of advanced western capitalism? Odd really given that neither model appears to be stable or perfect in its entirety, both representing forms of economic extremism, excess and various levels of maturity/immaturity. 

The issue is not debt alone, but the rate at which it has recently accumulated, especially post 2008 and the imbalanced nature of the economy upon which it rests.  Just because an economy has potential, just because compared to more mature developed country metrics China has some way to go in absolute terms, does not mean that the current force exerted at the turning point is inconsequential.

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No need to worry!

I recently came upon an article entitled “What You Can Do About The Upcoming Stock Market Crash”.  The title was tongue in cheek and perhaps unfortunately so given recent events.  Nevertheless, it made a number of important points about the difficulty of knowing when a market is at its peak and when a market is at its lows, and of knowing in which direction and by how much a market is going to move at any given point in time.  Much of this I agreed with, but not all:

When you think about it that risk and fear will always be there no matter how far the market goes up, down, or sideways. So what can you do?

Be prepared for a crash at any time. If you need to withdraw money in the next few years or you want to cushion the blows, then you need to diversify your portfolio with enough bonds, cash, or other assets that won’t fall along with the stock market.

Once you figure out what is right for your current situation you don’t have to worry about what happens because you are controlling the risks instead of letting them control you. That means you are safe to invest your money today and start earning your way to the freedom you want for yourself and your family.

Points 1 and 2 noted above are more or less correct, but the last point I have emboldened is where I diverge.  You are never ”controlling” risk, just diversifying it relative to return, and if possible, its covariance, itself a function of risk.  You cannot control risk, only minimise its impact through structure.  You are certainly not safe to invest your money today and there is no guarantee that you will earn your way to freedom. 

Return is an important consideration when accepting risk and many today who use simple mean variance models assume that expected returns are invariant and that risk is only volatility around this return.  In a general equilibrium, random, independent price movement model it does not pay on average to delay or defer investment (any benefit is purely attained by chance), but even here you are hostage to the probability distribution since the expected return in Monte Carlo land is only the average of many outcomes, some of which turn out to be quite disastrous from any level.

But expected returns do matter and while timing your investment to maximise your returns and minimise your losses is impractical and impossible for the market as a whole to do, making value judgements about market valuations and economic cycles to inform you of the boundaries of return and its significance is I believe worthwhile if you possess the expertise..  Where people run into trouble is where they either lack the knowledge and expertise to make the type of judgements needed to define the boundaries of expected return, and its impact on structure, as markets and economic cycles mature or react to market falls and meteoric rises as if one is the end of the world and the other its never ending bliss.

Deferring new risky investment at high market valuations is a value call and a discipline, but it is an act which relies on knowledge of the significance of valuation differentials.  It is one of my concerns that “we” have been taught that we should invest in markets at all times irrespective of the valuation, the cycle and the specific characteristics of either.  One of the reasons the world has been through innumerable crises since the late 1990s is because we have ignored significant accumulating structural economic and financial imbalances and the differential between asset valuations and economic fundamentals.  In a well balanced world we could probably ignore valuations and invest at will, ignoring volatility. 

But then again context is everything.  While one may not invest/sell at cyclical highs/lows there is little reason to sell all (high) and then attempt to reinvest all (lows) at perceived key turning points.  Portfolios should adjust to the relationship between valuation risks and the time frame of their liability profiles and it is here where we need to pay attention to valuation risks since these do have material impact.   As markets rise returns fall and the risks to the ability of assets to meet future needs increases, and vice versa.  When returns and risks pass barriers of significance that is where changes at the margin need to be made.  It is therefore not a question of timing but of tangible discipline and its benchmarks.

And, of course, I believe we are in the middle of a very long period of global economic and financial fragility, so safe is a word I would eschew for some time.

How far can we defer the next asset price crisis? Depends on how fat the tail of the distribution is!

I have blogged on fundamental liquidity issues recently and one point that I want to bring out is that the greater the divergence between asset values and GDP and the greater the divergence between broad MS growth and GDP growth, especially in slower growth frames, the “fatter the tail of the distribution”.  

Volatility at one level is a measure of the sensitivity of an asset’s price to new information, shocks to the system/de facto changes in the energy of the system.   It reflects changes in demand flows for assets which can reflect changes in risk preferences and risk/return expectations.   In a general equilibrium volatility is meant to be a static physical characteristic reflecting the fundamental nature of the asset and its relationships, but we do not currently have general equilibrium relationships and volatility is not a stable measure of anything.

Essentially when we have excess asset focussed money supply growth (EAFMS) amidst a slowing growth frame the “accumulated liquidity in” decisions exceed the “present value of future liquidity out” (PVLO) decisions.  In a sense liquidity (at its heart a function of the relationship between asset allocation decisions and C/S/I/P decisions) becomes more sensitive to short term  changes in demand flows and risk/return expectations, risk preferences and other factors.   As the ratio of EAFMS to PVLO rises so does the natural volatility of the system.

Why the tail?   Why not volatility at 1 standard deviation?  During periods of excess monetary flows demand changes are not in totality covariance issues (ie. relative attractiveness of one asset to another) but absolute flows that suppress relative price reaction.   In other words we see a fall in volatility throughout most of the distribution.   All the while the system due to EAFMS/PVLO imbalances becomes more sensitive to changes in flows, preferences, expectations and shocks.  

Given that the system because of its imbalances becomes more sensitive to small changes in any one factor, the bigger the divergence noted in paragraph A the greater the probability of an extreme risk event.   The greater the accumulated liquidity in to PVLO the larger the tail: the risk event and its probability increase. 

In reality, from a given point on, we can effectively discount the rest of the distribution in any analysis as a dynamically widening tail is merely a statistical constraint on the way we should be viewing risk.  We are only exposed to the wider risk distribution if forces suppressing risk remain influential.  

A Foray into the Fundamentals of Austerity in Anticipation of the Outcome.

A recent IMF report pointed out some supposed vast amounts of room available for the world’s economies to step up government borrowing to finance consumption, investment and production decisions.   Oddly the report appeared to ignore other forms of debt and material deterioration in key areas of the economic frame.  

When the crisis broke back in 2007 it was clear to me that monetary and fiscal policy would likely need to go for broke to support economic growth and employment at a time of collapsing asset values, debt defaults and a world wide retrenchment in expenditure of all kinds.   As it happened a great deal of that support went into asset prices and financial institutions.

But some years after the crisis, after a slow and drawn out recovery with interest rates locked to the floor, economies still appear to be borderline reliant on debt financed government expenditure.  Any attempt to reduce borrowing, to either raise taxes or cut expenditure to pay back debt would be considered by many to have an adversely negative impact on economic growth, especially at such low growth rates. 

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In the context of interest rate decisions you have to ask yourself just what are we waiting for?

I have seen that the IMF has asked the Fed to defer interest rate increases until we see clear signs of wage increases and inflationary pressure.

The request IMO is both scary and rationale given that so much of today’s National Income Accounting Identity (output=C+I+X-M) relies on factors that lie outside of its operation.  I speak of new bank generated loan growth given that income growth/distribution and investment growth still appear to be weak in the scheme of things..i.e. C+I the drivers. 

The last time the FRB delayed interest rate increases we had a debt financed consumption boom in the US followed by IR increases and a de facto financial collapse.   By raising rates we likely restrict one of the few modes of generating consumption growth in the US (note auto loans) and many other countries.  We also likely raise the impact of existing debt burdens on what are to date still historically low rates of income/wage growth.  

As such you have to ask yourself just what are we waiting for?  Well we need higher income growth, but not just higher income growth: we need a more equitable and fair distribution so that economic growth itself becomes less reliant on debt and low interest rates, and less exposed to the scary divergence of asset values. 

But the world is also changing in ways that question whether we can effectively outwait the inevitable: populations are aging and declining.  Areas where the frame can still expand in consumption terms, areas such as China, may be heading into their own period of slow growth and low IR debt support. 

Importantly will the status quo submit to a reconfiguration of the pie and can the world assume a less debt dependent economic raison d’etre?  

So yes, the rationale to defer interest rate rises is both scary and realistic, but it fails to answer important questions: what are we waiting for, how long can we wait, and are our hopes realistic? 

This is just a quick 3 minute post, but the issues are critical!

Critical perspectives on US Market Valuations 2…includes 17 charts

Many say that lower interest rates should raise asset valuations by lowering the rate at which future income streams are discounted.  This may be fine for high quality government bonds where coupons are fixed, but is not necessarily the case for equities where we are dependent on future flows (earnings, dividends, economic growth, CAPEX). 

What is the major determinant of long term real equity returns?  Earnings growth, and long term earnings growth is dependent on real economic growth.  If we look at real growth rates they are falling, and have been falling for some time.  This is part of the reason why interest rates have been falling; that is to accommodate falls in nominal and ultimately real flows.

The following shows annualised annual growth rates over rolling 15 year time frames (in other words geometric returns) compared to the Shiller Cyclically Adjusted PE ratio:

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Not a “Savings Glut” per se but a monetary excess amidst a period of complex global structural economic change!

If you stream through the data it is pretty clear that developed economy growth has been slowing for some time and that monetary policy has accommodated this adjustment with lower interest rates and a relaxed attitude towards money supply growth.  At about the same time these trends were moving ever closer to their sweet spot on the horizon (because we are not yet at peak of this particular movement) certain developing markets really got going, with the help of a fair amount of their own monetary stimulus but also by a reconfiguration of global supply chains and offshoring in key economies.  All factors combined to create a heady and dangerous global financial imbalance, a weak bridge cast across a widening economic divide.  No wonder it all came crashing down..but who was to blame?  The world’s central bankers who were blindsided into excessively lax monetary policy by a low inflationary world that had become obsessed with laying off and chopping and dicing of risk to those “who could best absorb and bear it”, or some of the finer strings in the mesh?  Well, some have chosen to blame excess savings in the emerging/developing part of the world, principally China, but this is all too pat.   The “savings glut” theory, if you can really call it “excess savings”, was merely a return of serve of part of the vast ocean of financial and monetary excess that barrelled through the early to mid 2000s.

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Are we in a financial bubble? Yes of course, we always are, but this one is different!

Many will be forgiven for feeling and being confused by the constant divergent chatter over market bubbles. 

Yes, we are in a bubble: I believe an extreme one in fact, but the natural state of the financial world relative to the economic is always one of a bubble; asset markets are always discounting the future, and the money supply that creates demand for assets and also goods and services has been growing for some time, as has the economy.  If a market is priced at x times historical earnings it is discounting future earnings and by doing so providing a valuable medium, or at least should be, for financing new investment and for facilitating the transfer of assets.   As the economy grows, so will assets and their prices and so will the bubble….and the bubble is the difference between now and future cash flows and the pricing of those cash flows. 

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Too Big Too Fail: a graphical analysis of the US asset bubble..

I have been tweeting about the relationship between asset valuations and GDP and a number of other metrics recently. 

My point for some time has been that the relationship between asset valuation and GDP, amongst other reference points, is excessive and out of alignment with slower GDP and income growth.  As with many of my other posts the point is this: the financial economy, asset and debt valuations and the complex financial system linking them, has become much bigger and therefore much more important to keep alive.  I would go as far as saying that the financialization of the global economy has become too big too fail, an extension no less of the banking dilemma.  

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Is Canada’s Mini Golden Age behind it?

I remember back in the 1990s looking at long term Canadian stock market performance and thinking how lacklustre it had been.  Since then of course things changed: while many markets have fallen back below levels reached in the 1990s (UK, France, Japan,  Italy) Canada’s stock market, up until recently, has been ratcheting up one peak after another; its markets have behaved more like developing Asian markets (South Korea, Hong Kong etc).

Commodity price and production increases have played a large part in much of post 1990s economic performance as has a considerable debt financed house price/construction boom and other debt financed consumer expenditure.

With the recent hefty collapse in oil (other commodity prices have been falling for a while too) it is worth asking whether Canada’s mini golden age has passed.   Certainly the boost that came from a debt financed property market boom is unlikely to be repeated and the consequences of debt more likely than not to weigh on future economic growth.  Additionally, China, a key figure in the growth of world trade and demand for commodities post 1990s is slowing down. 

But what of other dynamics?  Well population growth and aging are very important and have likely been a major factor in slowing global growth.   If we look at employment growth between 2000 and the present point in time we see that Canada has significantly outperformed the US and a good part of its economic performance has likely been due to this superior metric:

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Recently a Statistics Canada report eulogised Canada’s population growth, the highest amongst G7 economies but I see more troubling trends behind the data:

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The age 65 and over population is expanding rapidly at the same time as under 20s has actually been falling.  Back in 1990 12.5% of the US population was over 65 and 28.8% was 19 and below.  In Canada the respective figures were just under 11% and 27.7%.  By 2013 US over the age of 65 had risen to 14.14% and those under 20 had only fallen to 26%.  In Canada the respective figures were 15.3% and 22.3%.  The trend is divergent: the working age cohort in Canada started at a higher level and has now shrunk to a lower level and looks set to fall further.

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We can see the growth rate of the key 20 to 54 age group has been declining steadily.

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We also note that employment growth in the 20 to 24 age group (and hence the 20 to 54) had benefited some from a recovery in growth (long since past) in the 0 to 19 age group from the mid 1980s to the late 1990s.   This has now worked its way out of the system.

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Canada has seen relatively strong employment growth from the late 1990s to around 2008, which had held up reasonably well post 2008.  But if we assume that the 0 to 19 age group is declining and that the surge in employment growth has been due to a temporary surge in growth in the younger cohorts, expect employment and economic growth to suffer.   Also expect demand for highly priced properties to abate.

Poor demographics and high levels of debt combined are highly deflationary.  Moreover high levels of debt and slow economic growth risk further weakening population growth, compounding growth and debt problems.   This to my mind is a key reason why we need to worry a lot more about debt levels.   

High savings can mask complex debt spirals: brief addendum to differences between debt and saving..

In a recent blog I touched on issues of definition with respect to savings, debt and money supply.   A recent blog by Michael Pettis also touched on excess savings in high growth, debt driven, over extended gross fixed capital investment led cycles…phew.   Today Jesse Colombo @thebubblebubble tweeted that “bubbles can form with 100% down payments.  Credit is not necessary to form a bubble”.

It is an interesting point.  You can get a localised bubble without credit/debt expansion and this is where consumption demand and/or asset focussed demand plonks itself overly on one particular sector of economic activity or asset class.   This would draw resources/demand away from other asset classes or other economic sectors.  But it would show up in relative demand for other asset classes and other areas of demand.  In other words some areas would deflate and others would expand.  The damage as the bubble burst would be due to misallocation of resources, if this impacted capital and human investment allocations, or merely a revaluation of asset classes.

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Some people are confusing bank deposit creation (loan growth) as saving..this misses the point

Some people seem to think bank loans and savings are one and the same thing..in other words if a bank lends someone $10,000, some believe that this instantly becomes savings in someone’s hands.  I do not believe it does.  They seem to think that excess savings is synonymous with too much debt…I find this incredible…

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With monetary transmission impaired we may be in a perpetual “Sword of Damocles” moment

It may be that the monetary transmission mechanism is impaired through the structural imbalances that have developed within global economies over the last 20 years (+/-). If the transmission mechanism is impaired then we are in a perpetual “Sword of Damocles moment.”

The recent IMF blog, “The New Global Imbalance: Too Much Financial Risk-Taking, Not Enough Economic-Risk Taking” introduces a well known pre existing dynamic as “a new global imbalance”:

Policymakers are facing a new global imbalance: not enough economic risk-taking in support of growth, but increasing excesses in financial risk-taking posing stability challenges

We have been in a declining capital and human investment scenario for some time (discussed in many a recent blog), in many key developed economies, and we have been in a paradigm of increased financial leverage/asset focussed money supply growth.  This is not new and is the primary reason why we are pinned to the economic floor with the proverbial boot pressed to our throats.  I discussed this also in a recent blog…  

The IMF rightly points to the risks posed by the shadow banking financial system:

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Krugman: bubbles are good while they last because they prop up demand…

“It gradually becomes clear, however, that they’re each living out their own improbable fantasies, and Lister, Rimmer and The Cat must accept the fact that they’ve not returned to Earth, but are trapped within an addictive virtual reality called Better Than Life, a game which is killing them, but is incredibly difficult to escape from

The title of the blog is a shortened statement from a Paul Krugman article, Why Weren’t Alarm Bells Ringing?, the larger part of which I reproduce below.  The opening paragraph is an excerpt from a Wikipedia commentary on the first Red Dwarf novel. 

And now to Krugman’s article:

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The Geneva report and my points on the debt/asset value/IR chokehold

Many of the points I made in my choke point blog are also reflected in the latest Geneva report, Deleveraging? What Deleveraging?

One thing I would like to touch on before I highlight excerpts from that text is that high levels of debt and misallocations of capital may well be a feature of many a boom, but what makes the current situation much different is the fact that interest rates lie on a lower bound, almost incapacitated by a higher bound debt level, itself tied to highly valued asset markets.   High debt levels and weak growth dynamics are dangerous, irrespective of whether you are undecided as to whether high debt led to growth or low growth to high levels of debt, although I tend to believe that the reality is that weakening developed economy growth dynamics accompanied the debt build up prior to the onset of the crisis.  Beyond that point in time, high debt levels I would say are clearly impacting growth.

Whereas all significant debt misallocations have an impact on subsequent bank lending and new credit growth (the stock of broad MS is tied to these low or non performing loans), not all such instances have occurred at such low interest rate levels.  I think this is key, critical and as the Geneva report suggests “poisonous” intersect, although the report itself strays from emphasising what I consider to be the greater risk of high debt levels at low IRs..

Another point that I have laboured is the present value of future output growth or national income relative to debt is out of balance and this is the first time I have seen explicit reference to this in any other document I have read.

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Thoughts re a simple QE model of asset price bubbles…Will this bubble burst or will it collapse under its own weight..?

In a recent tweet I made the following comment:

“Bursting implies force>than constraint, collapse implies constraint>than its force”

In a recent blog post I discussed the large build up of money supply in the US (this is pretty much replicated across the globe) and the fact that money supply in excess of nominal GDP growth is likely asset focussed.  My point in this tweet was that a bubble either bursts, or deflates, or collapses under its own weight. 

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