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.