On the one hand, you have reality. Over 20 million jobs were lost in April, or more than 13 percent of employment. The other day I linked to a study suggesting that over 40 percent of these job losses are permanent. And there are more layoffs pending.
On the other hand, you have illusion.
The technology-heavy Nasdaq Composite Index entered positive territory for the year, erasing much of its losses from the coronavirus-fueled rout. Other major U.S. indexes also notched strong gains for the week. The S&P 500 rose 3.5%, while the Dow Jones Industrial Average advanced 608 points, or 2.6%. The Nasdaq Composite added 6% for the week.
I am going to offer a view of the economy. Feel free to disagree with it.
You don’t have to tell me that financial markets are saying something different. I already know that. The markets believe that today’s economic slowdown is temporary and that today’s low inflation and interest rates will last a decade. My way of looking at the economy implies something close to the opposite.
And you don’t have to tell me that typical macroeconomists disagree with me. I know that, too.
I have been re-reading my book Specialization and Trade. I like it even more now than when I wrote it (which is by no means my usual reaction to re-reading my other books).
The essence of economic activity is not spending. It is not the Fed trying to influence nominal GDP (sorry, Scott S.) It is patterns of sustainable specialization and trade. Emphasis on sustainable, which means with durable profits.
The fundamental problem with our economy in recent decades is that it has been fueled by debt. Debt gives rise to patterns of specialization and trade that are fragile. When adversity hits, all sorts of businesses lose viability, and large numbers of jobs get lost. It takes a long time for entrepreneurs to discover new patterns of specialization and trade. With a debt-fueled system, the pattern is long, slow recoveries and sharp, sudden crashes.
This WSJ story on the mortgage market gives you an idea of the sort of fragility that I am talking about. Although I will give a brief excerpt, you need to read much more of the story to appreciate it.
Nonbanks also have expanded in the crucial business of servicing mortgages. They now service roughly half of them, five times their share from a decade ago, according to the Urban Institute.
These nonbanks have no ability to withstand a drop in mortgage payments. They are supposed to have a simple job of passing through mortgage payments to pay property taxes, insurance, and the issuers of mortgage securities (usually Freddie and Fannie). They do not have the capital or the staff to handle a rash of delinquencies.
Households are fragile because they have houses and cars that they bought on credit with no margin of safety. Businesses are fragile because they finance inventory and equipment with debt, again with little or no margin of safety.
The financial sector supplies this debt because it never has to worry about widespread defaults. The Fed and the taxpayers always come through to bail out the banks and other “systemically important” financial institutions. In the case of the mortgage servicers mentioned above, the government will have no choice but to absorb the cost of handling mortgage forbearance (although I would have had the government approach the problem by offering loans to households that enabled them to make their mortgage payments). So the financial sector enjoys high incomes in good times and socialized losses during bad times.
The stock market and many economists think that the economy will “bounce back” quickly. That would be true if our patterns of specialization and trade had been robust, so that they could easily be re-started as fears of the virus subside. But running an economy on high debt makes it like Humpty-Dumpty. It won’t be put back together again.
Instead, new patterns will emerge. I would like to forecast that these new patterns will be robust. But there is a good chance that we will just have a new and different debt-bubble economy, and we will be going through the same thing in another decade or less. Until our policy makers drop their Keynesian and monetarist paradigms and instead see the economy in terms of patterns of sustainable specialization and trade, we will not have a robust economy.
“But there is a good chance that we will just have a new and different debt-bubble economy, and we will be going through the same thing in another decade or less.”
Allow me to steel man the stock market. I’m not endorsing this view, just playing Devil’s Advocate.
Most of the layoffs are low wage jobs. Hairdressers, waiters, etc. The economy hums along without these people. To the extent they are unemployed the government sends them a check which they spend on basics like food and fuel (both fundamentally cheap right now) and rent payments to other people.
When the crisis passes (your prediction may vary) these people will get their jobs back. Maybe not the specific job they had (that business may have closed), but something just like it.
Meanwhile, we know the government is going to backstop most publicly traded companies and prices in general. This sort of thing hasn’t showed up in general price inflation (food, etc) for decades. It always gets pumped right back into assets. The closest thing to an affect that people notice is rising housing prices.
So you’ve got a choice. You can invest in government debt at 0% interest rates for the next 10 years and hope they allow a depression to happen. Or you can assume they do what they always do and buy into the stock market.
Also, as you noted in a previous post, it could be that the entire small business economy completely collapses, but that it simply gets bought out/replaced for pennies on the dollar by the big backstopped corporations. Fewer owner owned restaurants, more chain restaurants. That could combine the view that the economy will be shaky but big public companies OK.
My impression is that the people unemployed because of the crisis were disproportionately doing “Keynesian Jobs”, like low-learning-curve manufacturing labor back in the 50’s, precisely the kind that are quick to drop, quick to bounce back, in response to overall macro / political conditions.
The economy is like the body and has jobs like different muscle types. Some are skeletal and quick to grow or atrophy, and some are cardiac or smooth, stable and slow to adjust. They can’t respond well or quickly to big changes in demand.
Illusion? When the Fed pumps up liquidity like they have, it flows into financial assets. The stock market long ago lost its function of allocating capital in any rational manner. (Stock) markets no longer “believe” anything, they just want to know what the flow of funds is. Yet people persist in thinking the market is providing some sort of crowd-sourced insight into the whole economic future.
The Fed isn’t buying equities yet. It might be more accurate to say the Fed is making some asset markets less discriminating by supporting government and corporate bonds broadly.
Fiscal and monetary stimuli are institutional catnip, respectively, to the legislature and the central bank. This will be hard to change.
Why not imagine that large corporations are the entities in the best position to profit from the disruption of patterns of specialization?
“World will be same but worse after ‘banal’ virus”, says Houellebecq.
Same shit but more institutionalized.
My way of looking at the economy implies something close to the opposite.
Both avg. Macroeconomist and yourself could be right and wrong at the same time. Or the market simply believes our economy is Japanification with loads of fianicialization.
And isn’t one of the problems of specialization and trade make more household fragile in the long run? I bet even before COVID-19 spread, households did not feel as confident as they did in 1961, 1985 or 1997.
I would bet on the US having very slow to no population growth in the next decade. Trump’s efforts to reduce immigration have succeeded, and because of the pandemic and economic crisis, it is seems very unlikely that Democrats will be able to roll them back without paying an electoral price. Plus, the reputation of the country, already tarnished to prospective immigrants from India and China, is going to be in tatters to those two groups of potential immigrants and students. So the US will see very low levels of immigration in the coming decade. Boomers will start to die in larger numbers as they get older. And finally women of childbearing age overall will choose to have fewer kids than they were planning, or have none, in part due to the pandemic and the economic crisis.
So yes, Japanification. Not to mention that so many young people just want to move to the largest cities, just like in Japan.
Viz Arnold’s closing comment, “Until our policy makers drop their Keynesian and monetarist paradigms and instead see the economy in terms of patterns of sustainable specialization and trade, we will not have a robust economy.” While there is truth in this comment, the very large problem with economic policy is that it ignores the importance of the intertemporal, long-run budget constraint. As Herbert Stein famously wrote, “If something cannot go on forever, it will stop.” (AEI, “A Herbert Stein Sampler,” October 1, 1999). We cannot finance government purchases of goods and services and income redistribution with debt indefinitely, nor with such large amounts of debt as we have in recently. Arnold is right that we will eventually have to pay the piper, and this payment will be either in the form of higher future taxes or the rest of the world imposing higher interest rates on our debt. Either way, our future standards of living will be worse for it.
Future standards of living won’t be worse but maybe not quite as high as they could be in 2040, 2050 or 2060. I’m not worried.
Echoing Ramesh Ponnuru, we should let assume how markets are responding today is reflective of how optimistic they bare about today or even tomorrow. Inasmuch as what is going on today was anticipated or feared in March, it was reflected when the market crashed in March. Maybe it ‘should/should have’ dropped further, but then how much should it drop? Unless one has a pretty solid idea of that, then you can’t confidently say it has dropped too little or not enough or purport to infer what market fluctuations today say about what markets thinks out today’s economy.
While one part of “Government” (municipal, county, state, federal, world-wide) blithely flings currency at it’s largest donors another part will tighten the tax collection screw.
Be prepared for a national (international?) version of California’s AB5 (https://leginfo.legislature.ca.gov/faces/billTextClient.xhtml?bill_id=201920200AB5) which makes individual contracting and LLCs illegal and places impossible risks on small business.
AB5 was adopted because tax collection from individuals and small businesses it too inefficient. Unionized state worker pension promises must be fulfilled at all costs. The most efficient way to collect payroll taxes is through payroll systems which extract it in large amounts at the time of payment…not months in arrears and in small amounts.
Entrepreneurs will not just be slow but unable to build new patterns. Welcome to corporate innovation…that worked so well in the 70s.
Fortunately, I had to shut down two small businesses in CA because of AB5. The virus bullet missed me by thiiiis much. I’m moving to Costa Rica or Mexico – maybe both.
Why is it debt that’s given rise to unsustainable patterns of specialization and trade?
It looks more likely to me that underlying institutional factors (e.g. law) has given rise to both unsustainable patterns of trade and finance.
All of the big problems I can imagine one pointing out have pretty obvious roots in the legal regime.
1. Corporations finance through debt as a tax avoidance method. Cash rich companies hold cash offshore as a tax avoidance strategy. Solution: reduce corporate income tax and debt-favoring loopholes (somewhat done recently).
2. People finance mortgage through debt as a tax avoidance method. And, legal standards for debt issuance were dramatically reduced. Solution: reduce or eliminate mortgage interest deductions (somewhat done recently), and raise legal lending standards.
3. People finance college through debt because regulatory regime has turned the BA and even an MA as de facto patents of nobility. Without one, you cannot even be considered for better jobs. Solution: Roll back educational requirements for government employees, contractors, and any sort of regulatory field it’s somewhat reasonable to do so in. Coerce states into doing the same.
4. This one will be controversial. Taking the “sustainable” nature of PSST seriously means that allowing free and unfettered trade with totalitarian countries that have such different notions of rule of law and individual rights should be reconsidered in light of the fragility it creates. I don’t have a single law to offer here, but if a country sufficiently different that the rights of its citizens (note, not simply their poverty… we shouldn’t stop trading with people because they’re poor) would be unthinkably oppressive to us, we should greatly curtail our dealings with them.
5. Also unpopular sustainable robust production might be a call for more supply chain regulation. Maybe this can be market driven, but I suspect that a big picture trade of “pay more for meat and fruit so working class Americans will do it for $15-20/hour vs. illegal immigrants at $8/hour might reduce some of the fragility we’re seeing at the moment. Solution: enforce immigration laws, and possibly make them more restrictive.
Young people have a coordination problem. They can’t individually get less education even if companies rollback education requirements. The first individual to do this will simply lose opportunities.
The market has a solution to the low priced food problem. Like fair trade coffee and organic food, just put a label on it that says “immigration status good” on the food packaging. The fact this is not already happening tells you something.
It might be hard to reduce trade with China on rule of law and human rights arguments because first, human rights reasoning doesn’t work when it comes from Republicans because the left doesn’t like Republicans and the right doesn’t really care that much about the human rights of foreigners. As for rule of law that’s not going to work if the U.S. does not support the WTO and give it a quorum of judges. The fact the U.S. has decreased its support for the WTO means the U.S. prefers to assert power. I don’t think I need to point out that this is the opposite of a rule-of-law method of dealing with China.
This isn’t really an argument against in the long-run. The goal here isn’t to totally eliminate people going to college, but to influence people at the margin. The marginal student is, by definition, already poorly served by incurring a huge debt and going to college The Marginal Cost = The Marginal Benefit. A small reduction in the MB (effected by a decrease in the relative benefits of college grad employment benefits will be effective). This is econ 101- In the long-run, the first order effects are sure to dominate the sort second-order effects you are talking about.
If it’s not happening now, that means it’s impossible. “Fair trade coffee and organic food” haven’t existed forever either.
Generally, these kinds of arguments aren’t substantive points, just “don’t try because you might fail” hand-waving. It’s the most unimaginative sort of thinking, because starts looking at the results of the status quo instead of the incentives underlie and influence it.
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As a side note, I’ve noticed that lots of scientists and economists and people in general seem to have developed strange innumeracy that’s expressed as a backward understanding of first-order and second order effects.
E.G. “We should lie about the effectiveness of masks, because some idiots might think wearing masks makes them immune”.
This is a concern that the second-order effect (the adjusted behavior change or Peltzman effect) will be worse than the first-order effect (the direct effect of the policy change). But this sort of thing has been researched ad nauseum and the consistent result is that direct effects dominate.
The lesson here is simple. Tell the truth. Implement the smart policy. In the masks case, let the occasional idiot think he’s immune, because the much larger number of sensible people will benefit from reduced disease transmission from masks.
In the education example, let the occasional idiot make a bad choice to go to school or not in order than the much bigger number of people at the margin have a broader path to success.
In the food example (and in general entrepreneurial and regulatory situations), experiment and see what changing incentives does instead of assuming that whatever is represents some conclusive result of a process. Processes are ongoing and what “is” is often the result of underlying regulatory barriers that are unlikely to change unless faced with pressure to do so. In that event, relying on “the market” to do so misses the point entirely.
Thank you. I see lowering the benefit is a means of coordinating young people.
Quote…”The game works best when there is a referee, and for nearly 25 years a group of seven judges at the World Trade Organisation (WTO) has done the job. But on December 11th this body will cease to function, because America is blocking new appointments to it. ” from the Economist in November 2019.
Until our policy makers drop their Keynesian and monetarist paradigms and instead see the economy in terms of patterns of sustainable specialization and trade, we will not have a robust economy.
But even if our policy makers saw the economy like this, don’t you think they would just misinterpret ‘sustainable’ as ‘non-innovative’?
Forgive the cynicism . . . .
That’s exactly what I thought when I saw the word “sustainable”. Perhaps “prudent” might describe what is intended.
Is the converse true? If our policy makers _do_ drop their limited paradigms and see the economy in terms of patterns, does that lead to a robust economy?
Honestly, I think PSST is a more complete model of more of the economy. But I don’t see how policy emerges from a PSST viewpoint that leads to more robust (whatever that means – I don’t even know what metrics would show that in PSST) results.
If I own a company, and that company has more capital, that one firm is more resilient. But it also follows that entry was considerably more difficult, too.
Is a less debt driven system really more systemically resistent? If the country had been filled with restaurants with 4-6 months more cash reserves, they would still end up going under, just more slowly. If they didn’t recover via debt, the sector would rebound much more slowly, wouldn’t it?
I asked the same question in “what do we want people to learn from the crisis”?
It makes sense for people and companies to have enough liquidity to weather a crisis. It’s not clear though that we want everyone to learn from this crisis “horde cash and don’t take risks.”
I think the worry with debt is more of the “could never repay even if everything went really well”. Like people that make their minimum monthly credit card payment and therefore aren’t “in default” even though they have no clear path to ever repaying the debt.
I’m not sure which of our political ‘leaders’ you all are hoping will change their thinking. For an example of what you’re dealing with see — “F–k Elon Musk” as a political platform.
https://nypost.com/2020/05/10/california-pol-tweets-f-k-elon-musk-amid-plans-to-move-tesla/
Only states with wide spread ownership of firearms will be able to ward off the good intentions of pols like the above mentioned.
I think we are past economic models and nuanced niceties at this point.
The illusion is that NASEQ is a fair index.
Not true, the investors are mainly investing in Microsoft, Amazon , Google and up until today, Apple. They are selecting the traditional, long term tech companies.
By the way, I really liked Kling’s “Specialization and Trade” when it came out and will reread it again soon.
Should we be “shorting the market”, as Tyler sometimes says?
Or are the time horizons too unclear?
I can commit to teaching my young children about PSST someday, but is there anything to be done now?
It’s asking a lot of our patterns of specialization and trade that they be robust *in the face of the pandemic*. Rather, (it is likely that) a lot of businesses that were viable before the pandemic will not be viable afterwards. And this is true quite independently of the degree to which they were leveraged.
So I do not understand why you think that the painfulness of the transition to a post-pandemic economy will be the greater the more debt there had been. If the owner of a business has no debt, he bears the whole burden of his bankruptcy. If he has a lot of debt, the burden is shared with his creditors. But the burden, at least in dollar terms, is the same. And the difficulty of finding new ways of doing business is also the same.
“The markets believe that today’s economic slowdown is temporary and that today’s low inflation and interest rates will last a decade. “
Aren’t those two things mutually exclusive? That is, if the economy grows strongly, shouldn’t interest rates and inflation rise?
The business activities that are worthwhile are those that generate cash flows with positive net present value (NPV). The cash flows from such activities can be divided up in uncountably infinite ways, one way being into claims owned by equity and (risky) debt holders. I think of Modigliani and Miller as saying that the way the cash flows are divided up, the so-called capital structure, doesn’t matter because the total cash flows and underlying business activities remain the same. Kling seems to be suggesting that the division of cash flows does matter in that if debt holders own claims to too much of the cash flows, then the cash flows will become more “fragile” even though the underlying business activities generating those cash flows hasn’t changed. I’m not sure whether Kling’s claim contradicts Modigliani and Miller or whether he has identified some sort of “transaction cost” associated with debt and those transaction costs are what turn the cash flows into fragile ones.
My impression is that Kling’s claim is that the government is bailing out private businesses via debt markets. So that means that the equity owners of businesses that load up on debt see the upside from that leverage, but not the downside. Because the existence of the debt allows the government to funnel extra cash flows to the business that they would not get were they financed more by retained earnings.
The 1920’s saw strong economic growth, which was fueled in part by consumer debt and debt-fueled market speculation. (both probably milder than today)
The reliance on debt was pretty well pounded out of the American people during the Depression, and by the end of World War II we had an economic boom fueled by savings instead.
We may be entering another era where savings becomes the way to buy things and to invest in expansion. The question is, can we stomach a lost decade of bankruptcies and collapses?
I know this is very impressionistic, but I sense it is the right question.