Discourse on a possible economic framework, its policy consequences, and use in financial markets (longer read)

Note: Due to the political nature of this discourse, I give a disclaimer that this is an economic framework that I am continually looking to inform my opinions on. It is not the case that these are strong-held convictions, rather ideas about economic policy I am developing and following to what seem to be their logical conclusions to aid understanding macro markets. My views are subject to change as more information comes to light.

The aim of this discourse is to detail a possible relationship between credit, wages, inflation, and interest rates and how they help us to inform our view on the strength of an economy so that we can understand the effectiveness of its political institutions and administration, understand where it is in its business cycle, and eventually come up with trade ideas based on these views.

The most important part of this is having an understanding of credit and credit cycles. This is because credit is what helps to increase the supply of money in the economy. This is an idea that follows from the monetarist tradition in that the supply of money in the economy is what increases economic growth. What’s also important about credit is seeing to whom it is flowing. Generally, the biggest consumers of credit are consumers, who use credit to buy products and services, corporations, who use it to increase the productivity of their business operations, financial institutions, who use it to provide liquidity to financial markets as well as lending, and finally the government, which uses it for any shortfalls in their budget to cover expenses. The interesting thing about consumer and corporate credit is that it depends very heavily on wages or profits increasing to be able to keep up with the debt load of having taken on credit. Furthermore, these increases in wages and profits come from productivity growth. Though it is certainly the case that short and intermediate term wages and profit increases can come from accommodative fiscal policy, such fiscal policy is not productivity growth, though it can lead to it in the longer term – more on this later. The interesting thing about credit consumption by financial institutions is that it is very heavily dependent on regulation. As we saw pre-crisis, there was a huge bubble in financial credit usage as a result of lax regulation which led to imprudent home loans lending and the securitized market that grew as a result. Thus, when the failure of these loans was realized, it was the banks and financial institutions that were most affected which has led to the regulatory regime of Dodd-Frank and has subsequently crimped the amount of credit available for lending. It is true that shadow banking has increased its market share in the wake of these regulations, but it cannot yet be said that it has reached the everyday American to the same degree a bank can. Finally, we have the consumption of debt by the government. This typically happens when government expenditure exceeds tax revenues which, in the US, we have done a pretty good job of for most of the past half century. The interesting thing about US Government debt is that it is used as a policy tool – in that when times are good we generally increase taxes and vice versa when times are bad which can be doled out to the different income brackets. 

The point of all of this credit from all of these entities is to increase consumption over and above that which would have been allowed only through productivity growth, and to even lead to new increases in productivity which would hopefully lead to a virtuous cycle. It is these possible increases in productivity growth that would help to increase wages and subsequently consumption, therefore keeping the credit cycle going. Thus, it can be said that credit growth has an intimate connection to inflation by helping to increase consumption and therefore prices. Thus, there would also seem to be a relationship between credit growth and central bank policy since the Post-Volcker Period due to inflation targeting policies. In this context, we might look at central bank rates as the rate required to maintain productivity growth, yet keep inflation at the target, what central bankers refer to as r*. However, as we all know, interest rates have been making historic all-time lows ever since the early 80s in the developed, western nations. So why exactly is this the case? From the above discussion we know that interest rate policy ultimately comes down to productivity growth, which is something that western nations have been lagging behind the rest of the world on. For our own part, we know that wages in the United States have been stagnant or even have been slightly decreasing since the 80s. A multitude of causes have been cited to explain this movement, chief among them being the liberalization of trade leading to the loss of manufacturing jobs to more competitive parts of the world, longer term demographic shifts which have led to a slow and steady decline in the fertility rate, an aging population that consumes less than it used to, as well as automation taking away jobs in both blue and white collar industries and concentrating the gains in productivity growth into the hands of the automators. As a result, both productivity and consumption appear to have tapered off from their highs or have remained stagnant coming into the 21st century, a marked shift from the immediate post-war period up until the 70s where inflation was seen as a public menace. All of these issues seem to have come to a head in 2008, where finally the debt/GDP ratio had gotten so extended with the stagnant growth of wages that we had a deleveraging period, where the amount of credit in the financial system had to make significant decreases not seen in previous business cycles to be payable by the individuals and firms that had contracted them.

This is what leads us into the post-crisis period where we see the above factors (free trade, demography, etc.) not only persisting, but even intensifying. This might be a possible explanation for the current flatness of the Phillips Curve in the US as well as other developed, western nations. It could be that we are at historically low unemployment at the same time that inflation isn’t increasing because wages aren’t increasing because there’s very concentrated spending in the US and other western nations today (ex. healthcare is ~15% of US GDP as a result of aging populations) meaning the gains are going only to certain sectors. It could also be that a lot of jobs have been shifted to other parts of the world, or that automation has permanently removed the need for certain jobs and that the demand for labor has decreased leading to a permanently low equilibrium wage for labor. As a historical analogue, the last time that this kind of event has been observed in the US was in 1929 where the economy virtually shut down and interest rates went effectively to 0, just as they did after 2008, and even went negative in certain parts of the world. Looking back to that time, we see that it was after 29’ that there was a political necessity for government action, which led to the New Deal and most famously Social Security. Though the resultant programs helped to get the economy back on track they did not do as much as the FDR administration would have hoped for, as it was really World War II that helped to lift us out of the productivity slump from 29’ which led to the period of post-war hegemony. Today, however, we pray for posterity that there is no World War III to lift us out of this productivity slump. A certain path to ruination! In the absence of positive demand shocks, it comes down to fiscal, monetary, and legislative policy to help increase demand in the long run.

Enter Modern Monetary Theory as a contender to solve the west’s current ills. It would seem that in the absence of productivity growth and subsequent consumer credit expansion, which is the most preferable option for organic economic growth, as well as strict regulations on financial institutions which have crippled their ability to take leverage and lend, the responsibility for the assumption and provident deployment of debt would fall to large corporations and the government. Of these, relying on large corporations seems to be a second-best option. This is the case because they have the ability to borrow at ultralow rates in the west, and build out projects that enhance productivity in the rest of the world which were already experiencing large amounts of productivity growth, while at the same time being able to avoid large tax bills due to the complicated and confusing nature of the US tax code. In addition, these large corporations are further able to avoid taxes and create an almost artificial wealth without increasing domestic productivity by using these ultralow rates for their stock buyback operations – effectively cutting out the need for everyman from Anywhere, USA to prosper for them to prosper. Small and mid-size domestic corporations, though they help to improve productivity in the US, might not be able to absorb as much credit as the task requires. Thus, we are left only with the US government that is up to the challenge. Under this view, running government deficits shouldn’t be seen as a ‘scary’ or a ‘bad’ thing. Sometimes they are necessary in getting productivity growth up… so as long as they stay temporary – more on this later. In this context, it might make sense to remove taxes on all entities, not just large corporations whom we can argue have a tendency to neither equitably pay out the gains from productivity growth, nor pay taxes to the government who will. The benefit of this is that since the upper middle class on down have a high marginal propensity to consume (MPC), it would provide an opportunity for consumption to increase and give a meaningful chance to jump-start productivity growth and subsequently credit and wages growth, leading to an upward spiral. 

The important point here is that this cannot be, nor is, an advocation for MMT as general policy, rather as temporary policy to get through this deleveraging period in which we find ourselves post-crisis. A continual application of this policy would lead to a very high chance of financial ruin. This is because American economic dominance is now under pressure from the rise of China, who aims to make the RMB the reserve currency of the world and supplanting America – the early indications of which can be seen through the introduction of Yuan denominated crude oil futures. Were we to be caught implementing this policy at the same time that the dollar dominance has drastically waned, which we are already seeing the early indications of through the de-dollarization during the trade war, it’s possible we would experience the same kind of hyperinflation and devaluation felt in Weimar Germany in the 30s, or many of the Latin American countries in 2019, leading to an utter and complete collapse. The other practical problem with this policy is that it might be an impossibility for the US to finance itself without any tax revenues – something there has been evidence for through the repo crisis of 2019. Most importantly, it opens the US up to huge moral hazard problems in that there would no longer be any need to be prudent in government spending which could lead to all of that risk of a devalued dollar not increasing productivity as much as disciplined legislation would have because the deficit spending was used poorly. 

Here, we return to the main point of this discourse which is to develop a framework through which we can understand the macroeconomy. As we’ve seen, our present issues are more a function of longer-term demographic, political, and cultural trends than anything else. As a result, the best response does not come from fiscal and monetary policy as that will only help us to smooth consumption in the intermediate term. Really, the best solution to these challenges is a cohesive legislative response that targets the underlying causes of lagging productivity growth. Examples of these legislations that the federal government might consider could be: 

• Reforms of the immigration system such that we don’t fall into the same demographic traps as Japan
• Reforms of the incarceration system such that we have more able-bodied people in the workforce to increase productivity
• Deregulation of the financial services industry such that lending and credit growth can get back to pre-crisis norms; or the rapid expansion of the shadow banking system to rival traditional banking institutions in their reach and to decentralize default risk
• Reforms of the tax code such that large corporations and ultra-high net worth individuals don’t take unintended tax breaks while giving tax breaks to smaller businesses and upper middle classes and below who make meaningful contributions to consumption and productivity growth that stay in the country
• Reorganization/reduction of government spending such that it is funneled only into the highest productivity-improving projects, or productivity-improving projects in general
• Reorganization of trade deals such that jobs stay in and come back to the United States.

 Thus, we have here a general model upon which we can seek to understand the historical context as well as present situation of almost any economy in the world. It deals with the relationship between credit, inflation, wages and wages growth, interest rates, and most importantly underlying productivity growth upon which all the others rest and is the result of strong legislative policy and governance in general. To jump from country analysis to broad based, global macro analysis, we need only do this type of research on the United States and China as these are the two biggest economies in the world, with the Eurozone a distant third. An understanding of these two economies through this lens would go a long way in helping to understand the evolution of risk sentiment through time, where it is now, and where it is going as a result of political and economic developments that are continuously happening (ex. Trade War). An understanding of credit flows would also help to inform our views on what assets capital is flowing to currently. As mentioned previously, in the current state of the US economy, large tax breaks are given to large corporations as well as ultra-high net-worth individuals. In the absence of an abundance of real economic growth opportunities at home, a lot of the capital finds its way abroad and into the equity market which has helped power the gains we have seen in this cycle. In China, where we have seen huge rates of growth as a result of the Chinese goal to double GDP in the last decade, the China 2025 program, and the subsequent largesse in credit growth, huge investments have been made into infrastructure, manufacturing, and now a shift towards professional services as they become more prosperous. As a result, along with very strong cultural norms and attitudes about the nature of wealth, we find that much of the credit created has found its way into the real estate real market as there is a fundamental demand for property to increase productivity. In this way, this economic framework would have also tipped a macro investor/trader off to the two biggest financial bubbles in modern history and allowed for massive profits… who knows where the next one will be?

Note: As this has been a bit more of a politically oriented blog, I have opted to stay a bit more high-level on certain topics as these are ideas I am mulling over and are not firm ideologic convictions. If there are certain things that you thought were interesting or wanted to learn more about what I was thinking, or had any comments, I would be happy to chat. I am a senior at NYU Stern double majoring in Finance and Philosophy, and am interested in a career in financial services/investment management. I can be contacted at snd314@stern.nyu.edu

Sources: 

How the Economic Machine Works - Ray Dalio

Big Debt Crises - Ray Dalio

Gold, the Dollar and Watergate: How a Political and Economic Meltdown Was Narrowly Avoided - Beaufort Wijnholds

The Monetary Policy of the Federal Reserve: a History - Robert Hetzel

The New Empire: An interpretation of American Expansion - Walter LaFeber

From Colony to Superpower - George Herring