Which Way Forward?

Which Way Forward? Some Suggested First Principles

Submitted by Rob Parenteau, CFA, and sole proprietor of MacroStrategy Edge and editor of The Richebacher Letter. He also serves as a research assistant to the Levy Institute of Economics.

Two of the responses to yesterday’s guest post reminded me of something I wrote back in the November 2008 Richebacher Letter (http://www.richebacher.com) . With a sharp move up in emerging market equities, banking stocks, consumer discretionary stocks, and material stocks, professional investors appear to believe we can go back to some semblance of the prior global growth model. Running an economy based on serial asset bubbles, consumer deficit spending, and perpetual trade deficits has proven risky, to put it mildly. The risks were identified well in advance by Dr. Kurt Richebacher and those who have been willing to apply Hy Minsky’s insights. Maybe it is time to find a more sustainable global growth model, rather than simply trying to prop up the old, clearly unsustainable model. To do so, it is worth considering some first principles that could inform a transition to a less financially fragile growth model.

After at least two major asset bubbles – first tech and telecom equities a decade ago, and then housing in this decade – many people have come to confuse an increase in the money value of financial assets with an equal or similar increase in the productive capacity of the economy. While there is no doubt that an increase in the money value of financial assets can encourage the expansion and shift the mix of the productive capacity of the economy – particularly its tangible capital equipment and structures – the two are not equivalent.

In the admittedly limited view of economics, wealth must be measured by the capacity to produce goods and services both in the present, and in the future. The money value of financial assets must be tied to the ability of the wealth holder to claim control over present and future products. In a 2006 keynote speech by William R. White, formerly head of the Bank of Canada, highlighted this distinction offered decades ago, but long since forgotten.

“As a corollary, I also agree with M J Bailey, who stated much earlier that this lifetime flow of produced goods and services depends on the production possibilities of the society and that ‘when no change at all has occurred in physical capital, land or labour or in their present or prospect productivities,… no new productivity or wealth has appeared to make possible any increase in future consumption’.”

The significance of this insight cannot be underestimated. If the tangible productive capital stock, along with other productive resources, is not enhanced during the course of an asset bubble, then the attendant surge of financial wealth is essentially illusory.

If productive capacity is not enhanced during an asset bubble, two outcomes are possible. Either inflation will tend to emerge as the spending power accompanying financial wealth is exercised against a productive capacity that has not kept pace, or a sustained trade balance erosion will prevail, as spending power is fulfilled by the productive capacity put in place by other nations.

White, in his poignant August 31, 2006 speech to the Irving Fisher Committee at the BIS near the close of his career, took this one step further, by noting what happens when households use portfolio appreciation as a substitute for saving out of income flows.

“Viewed from this perspective, the suggestion that countries benefiting from large increases in measured wealth, largely because of asset price increases, need no longer save out of income in the traditional way looks not only questionable but dangerous. Saving associated with illusory wealth increases is illusory savings. The end result must be a lower level of domestically owned capital and an associated lower standard of living over time. Moreover, such spending can contribute to current account deficits, with all the associated potential for mischief noted above. And to this must be added the diminished political authority associated with countries that become increasingly indebted. History has many lessons to teach us in this regard.”

Confusing appreciating financial asset prices with enhanced productive capacity is bad enough. Confusing appreciating financial asset prices with saving simply compounds the illusion. For many years now, Americans have implicitly sought to avoid the consequences described above – a lower level of domestically owned capital as foreign claims accumulate on the US capital stock through perpetual trade deficits, and an associated lower standard of living over time as domestically generated income flows are siphoned off to foreign owners – by pursuing serial asset bubbles that enhanced their financial wealth while distorting the mix of productive capacity.

White clearly foresaw the consequences of a household deficit spending spree built on the back of a housing bubble. As White puts is so clearly, revealing his careful study of financial stability during the course of his career, the asset values have disappeared, but the liabilities remain to be serviced.

“If higher house prices do induce an increase in spending, then the households that have done so finish with fewer assets or more liabilities than they would otherwise have had. In practice, debt levels have trended sharply higher in recent years as consumers have remortgaged their existing house at higher levels or have traded up. In spite of record low interest rates in recent years, debt service levels (as a proportion of disposable income) have also risen sharply and now stand at record levels in a number of industrial countries.

Should house prices fall, which is one way to re-establish a more normal ratio of house prices to rents, then the payback referred to earlier will be primarily at the expense of homeowners. It will then be evident that the wealth they spent was illusory; the assets have disappeared but the liabilities linger on. This would have negative implications for spending. However, even were prices only to stop rising, the growth rate of consumption would be affected due to the absence of the earlier stimulus of rising prices.”

Sustained or serial asset bubbles can introduce distortions. We should be prepared to recognize that by now. Financial wealth can become confused with an increase in productive capacity. Asset appreciation can become confused with saving out of income flows. Leverage can be built up on the back of asset appreciation that is not associated with an increase in income generating capacity, leaving borrowers susceptible to financial distress and economies susceptible to financial fragility down the road.

Any earnest attempt at putting the US and the global economies back on a robust, sustainable growth path needs to break through these confusions that have built up over the past two decades or more. Reviving asset bubbles is not enough.

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  1. Bam_Man

    Sorry to say so, but when your fiscal authorities, economy and banking system are all addicted to hyper-loose monetary policy, there is no other way forward.

    Bring on the next bubble. And then the next. And then the next.

  2. Edward Harrison

    Rob, very good piece. Your statement " If the tangible productive capital stock, along with other productive resources, is not enhanced during the course of an asset bubble, then the attendant surge of financial wealth is essentially illusory" is the key here.

    Richebaecher and most of the Austrian economists would tell us that we have just seen a period of huge malinvestment that will require more housing stock destruction a la Victorville, CA down the line.

    My question to you is this: is it possible to reflate this credit bubble again with some other asset?

    By and large, the consensus view is no – we have just seen a near terminal collapse in the financial system. However the key is the word 'near' because, unlike the 30s, we still have huge financial sector overcapacity with its concomitant credit bubble inducing effect – even after our brush with systemic risk.

  3. HoosierDaddy

    I wonder if the continuing "financial sector overcapacity" is behind the commodities bubble last year and 'son of bubble' this year. It seems like a parallel of the recurring currency runs of the depression that ultimately drove most countries off of the gold standard.

  4. GawainsGhost

    Well, I've said it before and I'll say it again. This whole thing is about people not knowing what money is or what money does.

    The real money is making money. It's as simple and obvious as that.

  5. DownSouth

    Excellent post.

    All the great empires since the dawning of the Renaissance have faced the same dilema. If the U.S. recovers from this tailspin, it will be first to do so.

    The uniqueness of Spain lay not so much in this contrast, as in the absense of a middling group of solid, respectable, hard-working bourgeois to bridge the gulf between the two extremes. In Spain, these people, as Gonzalez de Cellorigo appreciated, had committed the great betrayal. They had been enticed away by the false values of a disoriented society—a society of ‘the bewitched, living outside the natural order of things.’ The contempt for commerce and manual labour, the lure of easy money from investment in censos and juros, the universal hunger for titles of nobility and social prestige—all these, when combined with the innumerable practical obstacles in the way of profitable economic enterprise, had persuaded the bourgeoisie to abandon its unequal struggle, and throw in its lot with the unproductive upper class of society…

    The Castile of Gonzalez de Cellorigo was thus a society in which both money and labour were misapplied; an unbalanced, top-heavy society, in which, according to Gonzalez, there were thirty parasites for every one man who did an honest day’s work; a society with a false sense of values, which mistook the shadow for substance, and substance for the shadow.
    –J.H. Elliot, Imperial Spain: 1469-1716

    The contemporaries who bemoaned the economic decay of the Dutch Republic in the last half—more especially in the last quarter—of the 18th century were inclined to place the principal blame on the allegedly self-satisfied and short-sighted rentiers and capitalists, who preferred to invest their money abroad rather than in fostering industry and shipping at home and thus relieving unemployment…

    [T]he Dutch newspaper, De Borger…stated (19 October 1778) that the economic decline of the nation had reached such a pitch that it seemed as if ‘the body of the Commonwealth would shortly consist of little more than rentiers and beggars—the two kinds of people who are the least useful to the country.
    –C.R. Boxer, The Dutch Seaborne Empire: 1600-1800

    From the 1860s at least, the value of imports had consistently exeeded the value of exports. By ordinary assumptions such a situation should not have been possible. Yet Britain seemed to be buying more than it was selling overseas. How was the difference being made up, if not with earning from exports? The answer seemed to be that, under the system of “free imports,” the nation was living off its capital, exporting securities to finance current spending. Presumably this could not go on forever…

    “In the course of another generation,” (colonial secretary Joseph) Chamberlain warned, “this will be much less an industrial country inhabited by a race of skillful artisans than a distributive country with a smaller population consisting of rich consumers on the one hand and people engaged in the work of distribution on the other.’

    At times the transformation seemed already to have occurred. Toward the end of 1904 the former colonial secretary told an audience that

    “whereas at one time England was the greatest manufacturing country, now its people are more and more employed in finance, in distribution, in domestic service… I think it is worthwhile to consider—whatever its immediate effects may be—whether that state of things will not be the destruction ultimately of all that is best in England, all that has made us what we are, all that has given us prestige and power in the world.”

    –Aaron L. Freidberg, The Weary Titan: Britain and the Experience of Relative Decline 1895-1905

  6. David

    The Imperial Spain…DownSouth mentioned.. (sounds like the mentality of governments here in Australia)

    I wonder if this is the reality we are creating in Africa with the fashionable "End Poverty" campaign.

    Pumping US$72Billion p.a. through their governments
    (Recommendations of the MDG Africa Steering Group June 2008)…

    Instead of fostering the local business and trade that would be needed to bring in US$72 Billion in honest tax revenue so they could work their way up..

  7. Hugh

    “As a corollary, I also agree with M J Bailey, who stated much earlier that this lifetime flow of produced goods and services depends on the production possibilities of the society and that ‘when no change at all has occurred in physical capital, land or labour or in their present or prospect productivities,… no new productivity or wealth has appeared to make possible any increase in future consumption’.”

    This observation by William White could be summarized as: It's the real economy, stupid.

    Money that chases itself in the paper economy does not create wealth. Indeed as we have seen, it destroys real wealth by distorting the dynamics and priorities of the real economy.

  8. marin belge™

    This blog is getting more and more Austrian by the day. Same thing with "sudden debt" by the way. I appreciate this change of position. Doctor Kurt Richebächer was instrumental for quite a few of us in the understanding of the "global picture". I miss the gentleman who introduced me to Austrian economics in a peaceful and pragmatic way.

    It's about time that influential members of the US financial blogosphere re-visit Keynes, Friedman inheritage in a harsher way.

    Krugmanites beware:)

  9. Richard Kline

    So DownSouth, that's a stoic's scroll of societal melancholia yer unwinding there—but a good one. A few cavaets; a few accordances. Imperial Spain had something functionally similar to the reserve currency of the US (if structurally quite dissimilar) in the silver mines of the new world. Spain didn't have to be productive, or even continually solvent because it was perpetually minting the specie that other economic players in its sphere needed to make their own plays function. But a counterpoint is that Spain of that time never was a major economic power insofar as production in the European regional economy was concerned, whereas the US was and to a significant extent remains so. More on that below.

    Regarding the Dutch situation in 1778, I'm sure that you know given what you're reading, though others may not, that popular revolution followed very shortly after that date, initially overthrowing that 'rentier regime' before temporary supression by external reactionary forces. Indeed, the Dutch Revolution preceeded that of the French. Squeeze cellulose between a rock and a hard place, and you get an explosion. We're nowhere near that in the US, though. It'll take ten years, if not a generation, in my view.

    Regarding, 'if the US recovers it's standing, it will be the first to do so,' it's important to keep in mind that we are dealing with a very small sample of imperial or quasi-imperial economic powers, and with significant dissimilarities, not least in eras and institutional supports. It is hard to draw a valid conclusion from such a small set—and believe me, I ponder these questions closely myself—even if ALL prior instances are similar in trajectory.

    So what's different now? The biggest difference is that the US is bigger as a share of the global economy, as a share of the financial economy, and especially as a share of global consumption-demand. Even while credit-squeezed and endebted, the demand pull of the US outweights past comparable societies. Personally, I think that relative US decline _is_ highly probable to the point that any other outcome is higly _im_probable, but I don't think there is a conclusive case to that effect.

    So what's the same? US policy is completely tied to the past, and unable to revise/reform/reinvent. This was true of all the prior cases, and is the kiss of death, really. We must rethink and reform to avoid decline. We have been doing exactly the opposite for thirty years, and are doubling down under The New Guy. That implies no change in trajectory, and the trajectory as mapped is downward to lesser grace.

  10. skippy

    @downsouth and Richard K,


    As a result of France’s Louis XIV policies of expansionism, Europe was ravaged by two major wars, between 1688 and 1715. These wars disrupted trade between the Americas and the Old Continent, and Spain, highly dependent on the riches of the New World to finance her own policies of expansionism in Europe, suffered greatly. The first of these wars, the War of the Grand Alliance, ended in 1697 with the Treaty of Ryswick, but in 1701 another broke out, this time over the succession of the Spanish crown. Charles II had died childless, but on his deathbed, had named as his heir Philip, the grandson of Louis XIV of France. Leopold I, the Holy Roman emperor, who wanted to see his son, Archduke Charles, ascend the throne, did not kindly receive this decision. Leopold also wanted to prevent at all cost any close alliance between France and Spain. War broke out, with England and the Dutch on one side, and Spain, France, Portugal, Bavaria, and Savoy on the other.

    At the end of this period of hostilities, Spain was in dire need of financial relief. At the King’s order, a fleet was dispatched to America in order to bring back urgently needed gold and silver, which had been accumulating during the war. The eleven ships making up the fleet assembled in Havana in the summer of 1715. The fleet was made up of the Esquadron de Terra Firme, which served South American trade routes out of Cartagena, and of the Flota de Nova Espana which served the trade of Mexico and Manilla Galleons out of Vera Cruz, on the southeastern coast of present-day Mexico. The Griffon, a French merchant ship under the command of Capitaine Antoine Dare, was given permission to sail with the Spanish combined fleet. Now, every one was busy getting ready for the long and treacherous journey back to Spain. Additional cargo was being loaded. Inventories were taken. Fresh water and food items were placed aboard each ship. After a two-year delay, the mighty Plate Fleet was ready to sail home to Spain.

    The five ships of the New Spain Flota were under the general command of Captain-General Don Juan Esteban de Ubilla. Juan Esteban de Ubilla was himself on the Capitana, which carried some thirteen hundred chests containing 3,000,000 silver coins. There were also gold coins, gold bars, silver bars, and jewelry, as well as emeralds, pearls, and precious K’ang-Hsi Chinese porcelain which had been brought to Mexico by the Manila Galleons. The Almiranta carried nearly a thousand chests of silver coins, each individual chest containing some 3,000 coins. The Refuerzo carried eighty-one chests of silver coins and over fifty chests of worked silver. Another ship, a patache, carried some 44,000 pieces of eight. One frigate helped complete the Flota. The French ship Griffon, commanded by Captain Antoine Dar, had received permission to sail with the fleet. In his 1975 book, "The Funnel of Gold", historian Mendel Peterson estimated the value of the registered cargo of the combined fleet at 7,000,000 pieces of eight, which represented a real value of about $86 million (1975) of our money.

  11. skippy

    2… Around 4 a.m. on July 31st, the hurricane struck the doomed ships with all its might, driving one ship after another on the deadly jagged reefs. The ships broke up like wooden toys. Ubilla’s Capitana disintegrated, crushed on the reef like matchsticks. Almost all aboard were killed, including Captain General UbillaCapitan. The entire fleet was lost, and of the some twenty five hundred persons aboard various ships, over one thousand perished. Contrary to previous accounts by various historians, there is no historical evidence to indicate that the Griffon survived the terrible storm, and we can assume that it was lost, as were the two other ships of the 1715 fleet, around the shoals of Cape Canaveral.

    News of the disaster had swept the Americas and Europe much like the news of the Market crash would some 220 years later.

    Reference: John Debry, former President of HRD, inc.

    LINK: http://www.hrd1715.com/1715_Story.html

    Skippy…if we screw around the environment will punish us sooner or later, nearly every human calamity is exacerbated by the environment or is the precursor to the tipping point.

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