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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Calls for higher inflation targets

In a recent post,”There’s nothing left-wing about a higher inflation target”, Tony Yates called for an increase in the Bank of England’s inflation target from 2% to 4%.  Raising the inflation target for some reason would allow for higher interest rates that would provide the necessary leeway to combat economic downturns without being hemmed in by the zero lower bound.

While I do not necessarily agree with the statement I do agree with the dynamics that quite possibly underlie it.   Yes, if the inflation target had been higher central banks may not have been as aggressive keeping inflation under control and possibly inflation may not have fallen to current levels.   Interest rates may therefore not have trended down from the early 1990s to their pre crisis levels.

If interest rates had not moved downwards over this period then it is likely that we would have seen much less asset focussed debt creation and the foundations of the crisis that led to a precipitous immediate drop in growth and weaker growth post crisis would likely  have been somewhat curtailed.   The fact interest rates are hemmed in at the lower bound though has more to do with the dynamics of high levels of debt and their relationship with high asset values amidst the constraints of low economic/income growth.  In other words it is the past that has the greater weight, not the future.  So yes, clearly, without the debt accumulation and with higher interest rates we would possibly not be at this particular chokehold. 

But, interest rates did not fall solely because inflation fell, they fell because growth rates were also falling and because of a number of financial shocks to growth starting in the late 1990s.   In a sense interest rates fell to stimulate growth and anything that stimulates growth also risks stimulating inflation.   That it did not is a very moot point. 

In reality, all other things being equal, where inflation is caused by imbalances between supply and demand, the higher the inflation target you have the lower the interest rate target, and since I believe that lower interest rates have helped foster successive financial bubbles I am concerned over the integrity of higher inflation targets per se given the dynamics.   I would have preferred higher interest rate targets and less monetary stimulus even if this had meant a lower growth trajectory.   I can see little wrong with low inflation within a structurally stable economic framework.   

But let us suppose the argument is one of expectations and by raising the Bank’s own inflation targets so will the general public.  I think if this was the case the article should have clearly expressed it.  I do not personally feel that today’s deflation is led by individuals delaying expenditure in the expectation of lower prices tomorrow, although this does not mean it could not start to happen.   The question is, after all the best efforts of central banks the world over to stimulate growth over the last 20 years have led to the present moment in time of low interest rates and falling prices, how will putting an expectation of higher inflation into CB policy actually raise both inflation and interest rates?

Perhaps by raising inflation expectations we may cause consumers to spend more and save less.   But this assumes that people are spending less than they are capable of (the wealthy “1%” perhaps, but do they need to spend more?) as well as the fact that deflation is impacting the saving/spending decisions of consumers. 

Personally I would rather have seen a higher interest rate framework and reduced asset focussed money supply growth with lower potential inflation implications than the situation we are currently in.  It has less to do with inflation and more to do with structural economic integrity.   Trying to stimulate expenditure via every manner possible has led us into all sorts of problems.

A look at final Q3 GDP..was it really that strong? And what of the Frame?

One of the risks with short term data points is being fooled by their randomness.  I believe the US economic engine is slowing down and that weight of the past remains a significant head wind!

A number superlatives are cropping up re final Q3 GDP numbers:”fastest pace since Q3 2003” and others…

But what of the frame?   If we look at the average increase in real GDP over the last 4 quarters (average change in GDP over 4Qs/average GDP in prior 4 quarters) we see that real GDP growth is relatively low in an historical context and it is unclear whether the current trend is either a bounce back from earlier weakness or a position of growing strength.

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Importantly private consumption expenditure is still outsized with respect to economic growth and other important items such as machinery and equipment expenditure.  That is much of the growth in GDP to date has been due to growth in personal consumption expenditures: 

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QE and metaphysical dialogue

Once upon a time economic analysis was “relatively” straightforward…growing, slowing, boom, recession…all part of an upward cycle…even if you got it wrong, it never really mattered…most problems appeared consequences of excess growth…

Something changed some time way back and we have been edging in spurts, lunges and various headlong gallops to yet higher precipitous vantage points…the valleys along the way have also yielded some many interesting experiences….whether this change was a structural process that started some way back in the 1980s (secular stagnation and there are indications this could be the case), or the consequence of a misplaced emphasis on maintaining the stability of the business cycle in the late 1990s (LTCM, Asian Crisis..again consequences of this are clear), that saw central banks lowering interests rates to maintain the growth cycle, or the increasing levels of consumption and debt and widening wealth and income inequality that came hand in hand with lower interest rates and more “stable” and longer growth cycles and or financial deregulation, is a part of the overall complexity of the matter. 

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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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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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A debt/asset value/IR bounded endogenous monetary chokehold: Comments on “Patience is a Virtue When Normalising Policy”

The primary interest rate conflict is not between inflation and growth, but between asset prices and a potential asset price shock to growth and the financial system.  Increasing income inequality and weak wage growth keeps the US and other economies within a debt/asset value/IR bounded endogenous money supply chokehold.    A successive series of debt/asset bubbles and interest rate lows are not a succession of unrelated incidents but a tightening of an extremely dangerous grip.

In the most recent Federal reserve Bank of Chicago Missive,  Patience Is a Virtue When Normalizing Monetary Policy, much interesting information was imparted on employment trends…but  there was little comment about interest rates and their relationship with the build up of asset focussed money supply growth……this build up of broad MS was and still is reflected in highly valued asset markets and global debt accumulation.  Its magnitude can be gauged by the large surge in broad MS growth over and above nominal GDP growth.

“With the economy undershooting both our employment and inflation goals, monetary policy does not presently face a conflict in goals;

I foresee a time when a policy dilemma might emerge: Namely, we could find ourselves in a situation in which the progress or risks to one of our goals dictate a tightening of policy while the achievement of the other goal calls for maintaining strong accommodation.

So what happens when a conflict emerges?”

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Share buybacks..quantitative easing, secular stagnation and the risks of Myopic Share Virus..

The point about share buybacks is that they sit uncomfortably in a widening narrative of increasing inequality, weak income growth (worse at lower income levels), falling economic growth rates and disturbing trends in both human and capital investment. The backdrop to the narrative and one that threatens to envelop it as one are the burgeoning asset and debt markets, whose rise is at odds with the weakening fundamental growth prospects of many developed economies. Asset markets and hence debt are being supported, yet the fundamental underpinning to their longer term valuation, investment and growth in real incomes is being weakened. At some point the two, economic reality and asset market capitalisation will need to meet.

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The economic crisis was not a Monte Carlo event. My comments on Prof Sufi’s statement to Senate Sub Committee on Banking, Housing and Urban Affairs

I must admit I have not read the House of Debt, but I did read Professor Sufi’s statement to the Senate Subcommittee on Banking, Housing and Urban Affairs Subcommittee on Economic Policy.

While I agree with a lot of what Professor Sufi says about the impact of debt (I also share his concerns about income growth and about the worrying trend in auto loans) I disagree with the angle of a number of his statements:

How did we get into this mess? And why is it taking so long to recover? My research with Atif Mian at Princeton University suggests that the culprit is the devastation of wealth suffered by middle and lower income American households during the Great Recession.  The weak recovery is due in part to the lack of any rebound in wealth among these households since the end of the recession.

It was not the devastation of wealth per se but the accumulation of debt combined with invigorating domestic and global structural imbalances that led to the crisis.  The increase in the value of homes prior to the housing collapse was a consequence of excessive asset focussed money supply growth, lax lending standards and attendant growth in consumer debt.  To pin the blame on asset prices incorrectly ascribes blame to the natural risk and volatility of asset prices.

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Between boom and bust – US Economic context + data charts bonanza

The US economy lies somewhere between boom and bust as shown by the following graphical representation of real GDP growth.  Nevertheless, there are aspects of US economic growth that have boom type characteristics/risks; these are found primarily in the significant increases in auto focussed consumer credit and automotive production/capacityimage

Short term data has varied wildly of late; such can often obscure the underlying trend: what if we adjust for inventories and changes in consumer credit?   Well we see less noise for one, but we also see a slower underlying growth profile – yes, credit creation is part and parcel of growing expenditure but I still feel we are in a high debt/deleveraging and weak income growth dynamic that needs to be especially sensitive to growth in credit/debt.

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US debt service ratios

If you look at debt service ratios from 2008 to date you would be led to believe that consumer indebtedness has improved markedly.  In fact you would believe that conditions are the best they have been since at least the early 1980s.  But if you broaden your perspective you find that conditions today have not strayed too much from those conditions which have been in place for much of the last 14 years. 

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Weak demand dynamics and final Q4 US GDP

I was just looking through the GDP revisions: real growth was higher because a decline in the GDP deflator and nominal GDP fell from the last revision.  Nominal net exports also fell while health care expenditure was a significant upward revision.  

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My concern rests with the underlying growth rate of the US economy, especially domestic demand and the PCE component in particular.  I have referenced this issue before.

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Income inequality and the asset side of the equation…some interesting charts…

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If we have income inequality we are likely to have an increasingly asset focussed capitalist system.  That is the demand for non productive assets and securitised indirect investment in productive capital should increase as demand for goods and services as a proportion of national income declines. 

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Income disparity and capitalism may be an increasingly squeezed play in a robot world

Capitalism is not about wealth, it is about capital and its continuous productive employment.  Increasing inequality combined with rising wealth in non productive assets is essentially anathema to a structurally sound capitalist framework.

A big part of the problem is that key elements of the operational economic model, that which determines revenues and that which determine costs, have become disassociated from each other – marginal costs and marginal revenues need to be related.    Additionally the model itself is also suffering from leakage as less profit is reinvested and earnings are increasingly distributed to those who will accumulate and not eventually consume, with consequences for asset prices, which themselves have a feedback loop into the economic engine.

I was reading a couple of posts on FT’s Alphaville (Robots won’t make you rich for long & The UK’s squeezed bottom, charted) and a Stiglitz piece on Project Syndicate (Stagnation by Design).  The second Alphaville post provided a link to an important document on income disparity, produced by the Resolution foundation

I disagreed with the gist of the Robots won’t make you richer (a repost to Martin Wolfe’s Enslave the robots and free the poor), largely because the post confuses the price of an asset in the stock market (GM stock) with the value of the actual capital invested to produce the goods and earn the profits, but I felt that there was a thread between the subject matter of these different views that was worth expanding on. 

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Is the balance sheet recession over? Financial sector debt…

Financial sector debt (and as noted consumer debt) has fallen significantly since the crisis:

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Yet, if we look at the financial sector assets with respect to non financial sector credit market debt, we start to see an interesting picture:

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Secular stagnation… or a problem within a problem within a problem?

Two recent blogs on the FT’s Alphaville site discuss this issue:

Secular stagnation and the bastardisation of Keynes

Summers on bubbles and secular stagnation forever

At one level (the global whole) we likely have sufficient latent demand and supply dynamics to deliver the growth we need to maintain full employment levels and quite possibly to accommodate global debt – but that is all potential. 

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The third wave….

Zero Hedge showcases Hugh Hendry’s December news letter: it is worth reading.  He is correct in many of his observations on past events and possibly so with respect to near term global monetary policy.   The question he avoids of course, is “where does the madness end?”, because that part of the cycle that ended with the 2007 – 2009 crisis is starting to look like a lesser version of the one that Hendry envisions to be our immediate future.   He is clearly not a happy bunny….   The dynamics are nevertheless core!

And also – Hostages to Capitalism: Market Timing, Money Supply & The Economic Imperative (2008)

Inequality, Capitalism in crisis, the democratic option or the way of the demagogue

“Should the US increase its minimum wage?”

In a competitive market place it is unlikely that we would see the current large disparity between incomes and wealth, although we would see disparity naturally.  There is just no way that the pool of candidates able to run the few hundred of our largest companies is as small as it appears (human beings are de facto mass clones of each other) – in a competitive market place the pool of those capable of running a company would drive the price down.

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Briefly, while the last few crises might have been a surprise to many….

If you knew where to look, the late 1990s stock market boom and the developing build in debt was easy to spot, but the timing of the unwind was much more difficult.  You never knew how long asset prices were going to spiral higher even though you knew the pricing risks – the higher the market for a given economic profile the lower the future return.

Nevertheless, you knew when the trigger came that asset prices would react.   This was the same with the build up of debt (asset focussed money supply growth) and structural economic imbalances up to 2007: if you were aware of the magnitude you would have been aware of the risks.  

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Dark Side of housing-price appreciation

The blog title is taken from a recent VOX column and an excerpt is noted below.  Why am I emphasising this article?  Well the IMF has raised the same point about the Canadian economy and the Bank of England seems to be taking the same tack too with the UK.   But I have also raised concerns myself about the consequences of such misallocation of capital in the past (and I am not just talking debt but also more structural footprints), so the empirical evidence is interesting:

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Central Banks and bubbles..

I do find it funny to see how many rely on the words of central banks to determine whether markets are or are not in bubble territory.   Central banks these days are in the business of mind manipulation for the furtherance of asset price stability and economic survival and to expect them to malign the object of their obvious intent would be insanity.  Central banks are supporting asset prices for balance sheet purposes and to suggest these prices were in bubble territory would be counterintuitive.  

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