Rob Parenteau, CFA, serves as an economic and investment strategy consultant at MacroStrategy Edge, and edits the monthly Richebacher Letter. He also serves as a research associate at the Levy Economics Institute.
The Austrian School works with a world where money and finance can have repercussions on the real economy, primarily through the effects of financial signals and credit flows on the allocation of productive resources. So too did J.M. Keynes and Hy Minsky, and so too did Dr. Kurt Richebacher. It is a world most of us would recognize as part of our actual experience in the economy.
Contemporary macroeconomics has little room for money and finance to matter. General equilibrium theory, the intellectual pinnacle of the profession, has no room for money. Real business cycle theory has no room for finance – negative shocks to productivity, virtually from out of the blue, are the stated source of recessions. The Taylor rule, which ostensibly guides central bank policy rate setting, has an interest rate but no room for either money or finance, unless it is packed away in the error terms of the canonical equations. Recently, the Henry Kaufman Professor of Financial Institutions at Columbia University and his co-authors concluded the US housing bubble had little effect on consumer spending patterns. Huh?
Investors clobbered repeatedly by financial crises have good reason to search beyond conventional economic analysis. Much of the mainstream approach to economics has made itself irrelevant or at least foreign to our actual experience. Indeed, there is an argument to be made that the representation of human behavior in mainstream economics has approached qualities that would more likely be associated with people struggling with various degrees of autism (you will find this notion, which actually deserves to be taken more seriously, developed in greater detail at www.paecon.net: a quick glance at the quotes from contemporary economists in the left column will convince you that some members of the profession know there is a problem).
Apparently, repeated episodes of financial instability may also be getting through to not just investors, but policy makers as well. Much to our surprise, the latest World Economic Outlook published by the IMF reveals a macro framework that we believe those pursuing the unconventional insights of the Austrian School, Keynes, Fisher, Minsky, Dr. Richebacher and many others would largely recognize. In discussing the distinct characteristics of business cycles that involve a major financial crisis, the IMF staff discovered the following:
“…expansions associated with financial crises may be driven by overly optimistic expectations for growth in income and wealth. The result is overvalued goods,
services, and, in particular, asset prices. For a period, this overheating appears to confirm the optimistic expectations, but when expectations are eventually disappointed, restoring household balance sheets and adjusting prices downward toward something approaching fair value require sharp adjustments in private behavior. Not surprisingly, a key reason recessions associated with financial crises are so much worse is the decline in private consumption.”
While not as precise as the models developed by heterodox economists over the decades here the IMF recognizes the end of an expansion has something to do with falsified income expectations and mispriced financial assets. When financial signals promote misallocation of productive resources, profit income expectations are likely to be falsified as malinvestment or overinvestment is revealed. With earnings expectations falsified, equity and corporate bond prices are likely to fall toward “fair” or intrinsic value. As product and financial markets react to profit disappointments, households face layoffs leading to further income disappointments, as well as falling wealth, and consumer spending growth contracts. All of this should sound very familiar.
What about the recovery profile from recessions accompanied by major financial crises? Here, summarizing the results of the “Big Five” financial crisis episodes identified by economists Reinhart and Rogoff – which include Finland (1990–93), Japan (1993), Norway (1988), Spain (1978–79), and Sweden (1990–93) – the IMF has found some notable differences from the typical recovery trajectory.
“What do these observations tell us about the dynamics of recovery after a financial crisis? First, households and firms either perceive a stronger need to restore their balance sheets after a period of overleveraging or are constrained to do so by sharp reductions in credit supply. Private consumption growth is likely to be weak until households are comfortable that they are more financially secure. It would be a mistake to think of recovery from such episodes as a process in which an economy simply reverts to its previous state.
Second, expenditures with long planning horizons—notably real estate and capital investment—suffer particularly from the after-effects of financial crises. This appears to be strongly associated with weak credit growth. The nature of these financial crises and the lack of credit growth during recovery indicate that this is a supply issue. Further…industries that conventionally rely heavily on external credit recover much more slowly after these recessions.
Third, given the below-average trajectory of private demand, an important issue is how much public and external demand can contribute to growth. In many of the recoveries following financial crises examined in this section, an important condition was robust world growth. This raises the question of what happens when world growth is weak or nonexistent.”
Again, these are themes which should sound familiar to you. Professional equity investors were, up until the past month, very eager to count the green shoots sprouting from the monthly flow of economic statistics. Policy makers are eager to get banks to revive loan activity. Both of these constituencies appear to be ignoring that the way out of a recession that was triggered in no small part by an overleveraged US consumer may not be the same as the way in. The IMF staff, in contrast, may be starting to get the joke.
More importantly, the IMF staff seems to understand the unique nature of the challenge this time around. In the five prior recessions they studied with significant financial crises, the way out was not through releveraging of the private sector, but rather through improved trade balances, as global growth successfully floated all boats. If private sector spending is dampened by balance sheet repair and lender caution, then economic recovery prospects become more dependent on fiscal stimulus or foreign demand. This time around, the latter exit, the one the IMF identifies as most frequently employed in such situations, is somewhat blocked as the countries running the largest current account deficits wrestle with the most severe recession in many decades.
Calls for a second round of fiscal stimulus have begun to crop up around the US in recent weeks as fears the green shoots will fade to brown have been fed by a weaker than expected employment result, more signs of debt distress, and the continued ravages of home price deflation. That such calls are arising just weeks after investors were debating the prospects for hyperinflation dynamics taking hold, and bidding up commodity prices while selling Treasury bonds, tells you something about the deep uncertainty that still prevails. We are indeed in uncharted waters. What remains missing is any serious investigation of a new global growth model. The old one, based on consumer debt binges fueled by serial asset bubbles on the one hand, and headlong expansion of productive capacity in low labor cost countries that prefer to accumulate foreign currency reserves in part to manage currency pegs, is impaired enough that even the IMF realizes the scope of the challenges ahead.
On the US side, we know issues of private sector deleveraging, energy independence, water infrastructure, education and health care need to be addressed. Entrepreneurs, investors, policy makers, and economists best train their efforts in these directions to craft a plausible way forward from what is clearly not a garden variety recession with a conventional monetary or fiscal policy fix. If public/private collaboration is required to execute solutions in these areas because investors and creditors remain too short term oriented or too risk averse, then so be it. Reality has intruded on a global growth model that has proven itself unsustainable. Time to drop the delusions and move forward.