Relevant and even prescient commentary on news, politics and the economy.

Back to back quarters of Corp. profit declines… What could it mean?

I saw this tweet today…

Profits peak when the economy reaches its effective demand limit. A recession eventually follows.

How much can the psychology embedded in the tweet move market expectations?

I feel the economy is close to recession (link) but the data do not say that it has started. The business cycle could still bounce off this moment and keep going a while longer. I am waiting for more data from 4thQ 2015. But we need to keep an eye on the Animal Spirits of psychology.

It is another data dependent moment with Animal Spirits in these interesting times.

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Reflections on Tim Duy’s Projections for 2016

Tim Duy gave his projections for 2016. I will go through his 10 points with my reflections from the effective demand point of view.

1. He says that there will be no recession and the economy will stabilize by the end of the year. Yet, I see a higher probability of recession than he does. The economy is already weak from peaked profit rates and vulnerable from already having hit the effective demand limit. China is showing weakness and has also been vulnerable to the effective demand limit of the US. It is possible that the economy could stabilize by the end of the year if labor share continues to rise carefully and not too fast to spook business. The US consumer could come to the rescue and keep the business cycle alive. But then inflation would tend to trend upward and the Fed might be a little too confident to raise rates which could trigger weaknesses in business health.

2. He says that economic growth will soften to around 2%. That is a reasonable position.

3. He says that job growth will decelerate. I agree. He points to 2014 for where job growth peaked. That is when the economy reached the effective demand limit. After the economy hits the effective demand limit, employment must be matched by constraints in capacity utilization. Yet, there reaches a point where unemployment will stop falling. 2016 is the year that I foresee that unemployment stops falling and begins to level out.

4. He says that wage growth will accelerate. I agree. The economy is at its natural output level (potential output). The labor market will tighten and create pressures to raise labor share. We already see this happening.

5. He says that inflation will accelerate. I agree. He thinks this view is a bit wildly optimistic. However, even as we see weakness in the price of oil and gas, core inflation will tend to rise due to a rising labor share of national income. As output slows, prices will tend to push up. So I do not see inflation falling this year. And also, with China having problems, there is a hope that labor share will rise in the US. I share this view with Noah Smith. So problems in China could help resuscitate inflation in the US. But even so, cascading economic weakness globally would weigh down inflation.

6. He says that oil will end the year higher than it began. This is a complicated call. He points to production slowing. Yet, demand is also looking weaker from China who is playing to keep the price of oil at a floor of $38 per barrel. China is losing their strength to control the price of oil. Also, if there is a recession, then the price of oil would fall. My view is that the price of oil will stay between $30 and $47 barring a recession and grand geopolitical conflicts. The Saudis are forcing the price based on their own personal psychological desires. Will they change their whims? What would make them change? By keeping the price of oil low, the Saudis are trying to force North American producers out of business. This is a problem for the US because much of that investment in productive capacity could turn into non-performing loans. This will drive down the markets and potential output once again. But there is an election coming up, and meetings can take place behind close doors to affect the price of oil. It would be like the rumors of meetings with Iran to help Reagan become president during the hostage crisis at the end of Carter’s term. There are so many psychological and political factors around the price of oil that it is tricky to forecast it until the end of the year.

7. He says that stocks will be up, yield curve flattens and US dollar flat to declining. He says that equity gains would be modest. I do not see stocks going up. A year ago I said that the Dow would orbit around 17,300 and it has done just that over the past year. I have also said that the Dow would not go up much above 17,500 and that it would eventually drop from this 17,300 to 17,500 level into a recession. There is no sign of a strong asset bubble to inflate the market above this level after reaching the effective demand limit in 2014. Aggregate profit rates have already peaked when the economy reached the effective demand limit in 2014. The yield curve will flatten too. This makes the economy more vulnerable to a recession. And I agree with him that the US dollar will not rise much from this point. The US economy is not going to look that strong as we move through 2016, but greater problems elsewhere would support the US dollar.

8. He says that single-family housing will get strong. I am not so much in agreement. The job market and wage gains will not be so great as to have single-family housing take off. I expect it to keep trending upward but with only a small acceleration.

9. He says that the Fed will continue to raise rates slowly. I agree. The Fed is in a mindset that the economy is tightening up with slack still available to utilize. From my point of view, slack has already been used up as the economy has already reached the effective demand limit. The Fed can only raise rates very slowly when up against the effective demand limit of peaked profit rates. Still, I see that the Fed will have to think very hard about maintaining a pace to raise rates. The economy is more vulnerable than the Fed appears to think. But they want to get on a path to careful normalization. 2016 should be the year that the Fed realizes that they cannot get back to normalization. Then the debate will rage as to whether they should have raised rates more slowly starting a couple of years ago.

10. He says that productivity is a wild card. I will give the view from my effective demand research. If productivity starts to rise with the economy against the effective demand limit, history since the 1960’s shows that a recession will form. The recession will then release productivity from its effective demand constraint. So wishing for a surge in productivity would contradict a forecast of no recession. Yet, thinking along those lines with Tim Duy, it is possible and somewhat likely to see a rise in productivity. This would be a sign to me that a recession is forming.

May there be peace in your lives, family and communities this year…

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Is there a model in which a Country which borrows in it’s own currency has a Greek style crisis ?

usa = Greece ?

A challenge. Paul Krugman asks how a country like the USA could have a Greek style crisis.
In his Mundell-Fleming Lecture Krugman defined Greek style crisis twice ” a Greek-style crisis of soaring interest rates” and ” a Greek-style scenario of higher rates and a slump in the real economy” . He says there is no plausible mechanism.
I will ignore the word “plausible”.

First the US Federal government can’t default on dollar denominated debt (if it is considered as a whole including the Treasury, the Federal reserve banks and let’s toss in the Social Security Administration to keep them company). The Fed can create as many dollars as it pleases. The rough equivalent of default is monetization of the debt in which the Fed creates enough dollars to pay it, but the dollar loses its value. Another way to understand this is to note that the US Federal Government can inflate away the present value of payments on long term bonds. Losses to investors can be the same if a bond which pays cents on the dollar because of default and if a bond loses value because payments are discounted at higher market clearing nominal interest rates.

I will use “loss of confidence” to mean loss of confidence that a treasury is solvent so it will be able to pay its debts without default or extraordinarily high inflation. Like Krugman I will consider a loss in such confidence in a treasury which has borrowed in its own currency and will assume that the country in question is in a liquidity trap. I will also assume that fiscal policy can’t be changed quickly, that is that the US Congress is paralyzed (as it is).
I will attempt to avoid Krugman’s conclusion by changing the assumption about the form of the loss of confidence, by considering banks more explicitly and (mainly) by invoking the expected inflation imp.
Krugman argues

First, the principal determinant of long-term rates is the expected path of short-term rates. Normally we would only expect a large rise in long rates if investors expect short rates to rise sharply in the future. So we’re back to asking why the central bank would raise short-term rates; a Taylor rule would say that it will do so only if the economy booms or inflation rises (of which more below), and at the zero lower bound it would require a large shock before there would be any change. That is, focusing on the long rate does not seem to change the basic story.

However, it is possible (in theory) for there to be a large jump in expected inflation. In some standard models this can happen in response to a sunspot — a signal which doesn’t affect tastes or technology and so isn’t a shock in the ordinary sense of the word. One of these models include the overlapping generations model with money. But the more relevant class of models are standard New Keynesian models with a Taylor rule with too low a coefficient on lagged inflation.
Formal models don’t rule out such a “large shock”. Experience tells us that they don’t happen in developed countries (at least after the end of the German hyperinflation) but experience also told us that US housing prices don’t fall nationwide and that public and money center bank paid short term interest rates move together (for what it’s worth, I am very confident that such a jump in US expected inflation will not occur — this post is purely an intellectual exercize).

It can be impossible for a monetary authority to achieve low interest rates forever. High expected inflation and a low discount rate lead to hyperinflation and, in the end, to abandonment of the currency (at least this is what happened in Germany). In this case there would be no nominal interest rate on dollar denominated assets, because there would be no dollar denominated assets. I think high expected inflation makes high nominal interest rates inevitable even if the monetary authority is willing to accept high inflation.

An insolvent Treasury doesn’t have to choose between cutting spending, raising taxes or inflating away the debt, there are other options.

One way in which a Treasury in which no one has confidence can cover a deficit is by forcing some entity to buy its debt at a price it dictates. This is, in effect, a tax and would require legislation (recall I assume Congress won’t do anything). Relatedly, the Federal Reserve Board can and does force banks to hold reserves of high powered money — the sum cash in vaults and deposits at federal reserve banks. Each kind of disguised tax is called “financial repression”. To get to a Greek style crisis, I have to rule out financing debt by creating money and avoiding inflation by imposing absurdly high reserve requirements (higher than 100% of deposits I think).

I honestly think such a strategy might be ruled out by the insolvency of banks. In particular, an increase in nominal interest rates can make banks insolvent, since they borrow short term and lend long term. I think the protagonist of this story is the 30 year fixed interest rate mortgage — that is I stress the vulnerability of financial intermediaries which borrow short term and lend long term. In the story (at least) total mortgage debt is roughly equal to US Federal Government debt held by agents other than the Social Security Administration and the Federal Reserve System.
I think the cost of bailing out mortgage lenders could eliminate the windfall from the reduced value of long term public nominal debt.

The point (if any) of this post, is that a sharp increase in expected inflation and nominal interest rates can cause a slump in the real economy, because of the effect on banks. I think this is what Kenneth Rogoff had in mind (it might also be what Larry Summers has in mind in the current discussion).

Further rambling after the jump

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Can Systemic Financial Risk Be Contained?

 by Joseph Joyce

Can Systemic Financial Risk Be Contained?

Risk aversion is a basic human characteristic, and in response to it we seek to safeguard the world live in. We mandate airbags and safety belts for automobile driving, set standards for the handling and shipment of food, build levees and dams to control floods, and regulate financial transactions and institutions to avoid financial collapses. But Greg Ip in Foolproof shows that our best attempts at avoiding catastrophes can fail, and even bring about worse disasters than those that motivate our attempts to avoid them. Drivers who feel safer with antilock brakes drive more quickly and leave less space between cars, while government flood insurance encourages building houses on plains that are regularly flooded.

Is the financial sector different? The traditional measures implemented to avoid financial failures are based on attaining macroeconomic stability. Monetary policy was used to control inflation, and when necessary, respond to shocks that destabilized the economy. When a crisis did emerge, the primary responsibility of a central bank was to act as a lender of last resort, providing funds to institutions that were solvent but illiquid. There was a vigorous debate before the global crisis of 2008-09 over whether central banks should attempt to deflate asset bubbles, but most central bankers did not believe that this was an appropriate task.

Fiscal policy was seen as more limited in its ability to combat business downturns because of lags in its design, implementation and effect. A policy that established a balanced budget over the business cycle, thus limiting the buildup of public debt, was often considered the best that could be expected. Automatic stabilizers, therefore, were set up to respond to cyclical fluctuations.

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Ireland still isn’t back

Ireland remains, in some circles, a poster child for austerity’s success: It paid off its bailout loan early! It regained its 2007 Gross Nation Income per capita in 2014! Unemployment is only 8.9%! Don’t believe the hype.

Paul Krugman recently pointed out that Ireland’s employment performance continues to be dismal, especially in comparison with currency-devaluing, banker-prosecuting Iceland. Iceland’s employment now exceeds its pre-crisis peak by about 2.5% whereas Ireland is still, 8 years later, 8% below its peak. More specifically, Irish employment peaked in Q1 2008 at 2,160,681; in Q3 of 2015, the figure was still only 1,983,000.

Not only that, but in 2014-2015 (May-April), Ireland continued with net emigration, as 11,600 more people left than came to Ireland. This was a substantial improvement of 9800 over the April 2014 figure, but still the trend is that Ireland is exporting unemployment literally.

Things are obviously getting better in Ireland for those who remain behind. Jobs are being created, and the number of unemployed has fallen. The April 2016 immigration report (the data are only reported once a year) may finally see an end to net emigration. But Ireland is 80% of the way to a lost decade, and isn’t out of the woods yet.

Cross-posted from Middle Class Political Economist.

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