The risk of another 1937

Financial markets responded to the news of US economic growth jumping to a 4% annual rate in Q2 2014 by selling off. The reason was that faster growth in the economy would imply an earlier move by the Federal Reserve to raise interest rates and ‘normalise’ monetary policy. The Fed’s monetary policy committee said it was sticking to its existing ‘easy money’ policy, although it was tapering its rate of credit injection and stopping altogether in October. However, one Fed board member dissented and wanted a rate rise now. This spooked markets into reckoning that the era of cheap money since the Great Recession might soon be over.

The whole situation reminds me of the move to tighten monetary policy in 1937 during the Great Depression. Then it appeared to the US authorities that the slump was over and it was time to ‘normalise’ interest rates. On doing so, the economy promptly dropped back into a new recession that was only overcome when the US entered the world war in 1941. The reality was that the profitability of capital and investment had not really recovered and raising the cost of borrowing tipped the economy back (see my post, http://thenextrecession.wordpress.com/2012/08/06/the-great-depression-and-the-war/).

That is the danger this time also. The headline growth figure for Q2’14 was a 4% annual rate and the first quarter disaster was revised up to a contraction of -2.1%. But this jump mostly reflected a sharp rise in inventories, namely stocks of goods that companies are piling up and have not been sold. This contributed 1.7% points of the 4% uptick. This suggests that US companies may have produced more but cannot yet sell it all. We’ll see in the next quarter.

Moreover, if we look at the level of US gross product compared to this time last year, the growth rate in Q2 was only 2.4%, a much better gauge of the level of expansion that the annualised figure. So even if growth accelerates in the second half of this year, the IMF forecast for the whole year of 1.7% that I mentioned in a recent post is likely to be confirmed. If you look at the graph below, you can see that the red line of year-on-year growth is pretty static at about 2% a year.

Indeed, the US official statistics were revised in this latest report. In the three-year period 2011-13, the real GDP growth rate averaged exactly 2% a year, revised down from 2.2%. So the ‘recovery’ since the end of the Great Recession in mid-2009 remains the weakest since the Great Depression. And the gap between where the trend growth rate would have taken the US economy without the Great Recession happening and the reality remains unbridged, with some $1.5trn of output lost forever, or about 10% of GDP.

The majority of the Federal Reserve board remains reluctant to move on tightening monetary policy as the dissenters want. They stick to the view that there is still a sizeable gap between potential output and effective demand in the economy. This is the Keynesian view, as propounded by the likes of Paul Krugman and Larry Summers, who fear that that the US is in ‘secular stagnation’ that requires keeping interest rates near zero and more printing of money (http://thenextrecession.wordpress.com/2013/11/30/secular-stagnation-or-permanent-bubbles/)

The dissenters are growing in strength though. Recently the Bank of International Settlements (the central banks association body) published its annual report and raised fears that unending printing of money and credit injections was creating financial and property asset ‘bubbles’ that would eventually burst and renew the financial crash of 2008 (http://www.bis.org/publ/arpdf/ar2014e.htm). This was not a new debate kicked off by the BIS. The BIS pushed the same story last summer (see my post, http://thenextrecession.wordpress.com/2013/06/26/the-failure-of-qe-2/).

Jaime Caruana, head of the BIS, said the international system “is in many ways more fragile than it was in the build-up to the Lehman crisis”. Debt ratios in the developed economies have risen by 20 percentage points to 275pc of GDP since then. Credit spreads have fallen to to wafer-thin levels. Companies are borrowing heavily to buy back their own shares.Caruana correctly pointed out how stock and bond markets were racing up to new highs but the ‘real economy’ of output and investment was stuck in very low rates. This suggests a dangerous bubble as higher risk corporate leverage (debt) has risen to new highs.

And the Fed dissenter, Robert Fisher put it: “the money we have printed has not been as properly circulated as we had hoped. Too much of it has gone toward corrupting or, more appropriately stated, corrosive speculation.” And Fisher quoted Neil Irwin of the NYT who pointed out that “Around the world, nearly every asset class is expensive by historical standards. Stocks and bonds; emerging markets and advanced economies; urban office towers and Iowa farmland; you name it, and it is trading at prices that are high by historical standards relative to fundamentals.” (http://www.dallasfed.org/news/speeches/fisher/2014/fs140716.cfm).

A good measure of how far financial markets are out of line with reality is Tobin’s Q, a measure of the market value of stocks against the actual value of the stock of fixed assets owned by companies. This measure was invented by James Tobin, a leftist economist back in the 1980s.

The great collapse in equity prices in 2000, which led to the secular ‘bear market’ in stocks since then (see my posts, http://thenextrecession.wordpress.com/2013/03/30/its-still-a-bear-market/ and http://thenextrecession.wordpress.com/2014/02/07/waste-bear-markets-and-fictitious-capital/), was clearly suggested by Tobin’s Q peaking at an astronomical high then. The Great Recession saw the ratio drop below the historic average. But since then it has risen back to the highs of the 1990s. So are we due for another fall?

The BIS critique is really based on the ideas of the so-called Austrian school of economics. This school reckons that there are financial crises under capitalism but that they are caused, not by faults in the banking system or by flaws in the capitalist mode of production. On the contrary, the market economy is a wonderful piece of social engineering and the ‘invisible hand’ of market forces is the only viable way for economies to operate efficiently. The problem is that governments (departments of finance and central banks) interfere with the smooth operation of financial and product markets and try to fix interest rates or the quantity of money. This just leads to ‘malinvestment’ and credit bubbles. Then these bubbles will need to be burst like a blister to get rid of the poison of speculation, even if it leads to a slump in production.

Actually, the BIS does not adopt Austrian economics outright. It follows the work of Kurt Wicksell, a Swedish economist, and now backed up by the work of BIS economist Claudio Borio. They reckoned that modern capitalist economies with a large financial sector are subject to endogenous cycles of credit booms and busts spread over 15-20 years (Borio says 16 years – see my post, http://thenextrecession.wordpress.com/2013/02/10/why-is-there-a-long-depression/). The BIS reckons that if no preemptive action is taken, then the major economies, particularly the US and the UK, are heading for another credit bust.

These ideas are, of course, anathema to the Keynesians, who reckon the Great Recession was the product of a huge drop in ‘effective demand’ and the capitalist economy must be given huge dollops of ‘free money’ to boost demand before it can be allowed to stand on its own two feet. They reckon that, as demand has not fully recovered (unemployment may be falling, but wage income is stagnant and business investment is pitiful), the Fed’s printing presses must continue to pump out dollars and at the very least, the cost of borrowing should not rise.

However, stock market investors have become worried that the gravy train they have been on for the last few years as the Fed pumped in ‘free money’ to borrow in order to speculate in stock and property markets might be coming to an end soon. The strong headline US GDP figure and the split in the Fed’s board between the BIS and Keynesian wings was the trigger for a sell-off.

I think the stock markets are right to be worried, but not just for the reason of ‘uncontrollable credit’ that the BIS cites. There is also the productive sector of the economy. There is a huge gap between the value of financial assets and property prices and the productive growth in the major economies. And now there is a significant turn in profitability appearing.

Profits are the key to investment and the correlation between the movement in the mass of profits and business investment is well documented (at least for the US) – see my post, http://thenextrecession.wordpress.com/2012/06/26/profits-call-the-tune and my joint paper with G Carchedi, The long roots of the present crisis.

And US corporate profits have stopped rising. In the first quarter of this year, they fell absolutely for the first time since the end of 2006. When they fell in 2006, investment slumped about one year later and the Great Recession began. If corporate profits continue to fall, it will be a clear indicator of new recession in the offing just a year or so away, perhaps exactly when the Federal Reserve starts to raise interest rates.

It could be 1937 all over again.