Perspectives on Risk - Apr. 23, 2022
Debt Overhang As A Constraint; Lower Growth & Supply Shocks; Evidence; And We Are Raising Rates; Further Things To Think About
My thesis and operating framework for many years has been that three things have been driving long-term economic and financial trends: demographics, technological progress and trends in globalization.
We’ve recently tried to think through Zoltan Poszar’s assertion about the need for a Bretton Woods III to deal with possible emergence of a two-block world, and we’ve thought about the recent bout of inflation as having three components (stimulus demand interacting with Covid-induced supply shocks, Ukraine-war induced supply shock, US labor supply constraint)
Dan Gardner, who writes an informative substack PastPresentFuture, has a post about avoiding ‘temporal myopia’ - in other words, don’t be a Mr. Magoo and be ‘desperately nearsighted.’ Has a great Piketty story to relate. In that light, again trying to look further away …
Debt Overhang As A Constraint
We haven’t talked about the debt overhang in a while: it’s as if policymakers have either forgotten it exists, or have internalized the tripe interpretation of Modern Monetary Theory that deficits (and debt) don’t matter.
With that as background, I found this 36 minute talk by the iconoclast economist Lacy Hunt quite interesting. He suggested that there are two fundamental challenges with ‘a return to normalcy,’ namely:
A large and growing debt overhang
The ‘revolutionary design’ of the Fed actions, since they don’t know whether they can unwind it.
I’m more interested in the first point, as this might pose a constraint, or perhaps a dead-weight tax, on the underlying economics.
He starts by observing that US GDP grew at 2.2% annually up "‘until we became heavily over-indebted in the late 1990s’ such that GDP would have been 21% higher had that trend growth continued.
He challenges conventional thinking is that negative real yields are simulative, suggesting instead that:
investors are not going to be able to price through the risk premium on their debt capital, and they do not have incentive to invest in physical aspects of the economy, and that without physical investment you cannot get growth.
In highly indebted economies the evidence is overwhelmingly that the banks cannot price through the risk premium and the [money] multiplier falls.
[NB: remember here that part of the consequence of deglobalization on Western economies is the need for considerable infrastructure investment.]
He cites the 2012 work by Reinhart et. al.1 and summarizes their conclusions as:
The economic growth rate is reduced by slightly more than a third …, and
Since 2000 the US has fallen 50% below the trend rate … indicating the deleterious effects are increasingly disproportionate as the debt levels have escalated.
But why are the effects ‘disproportionate as the debt levels have escalated'?’ Diminishing marginal returns from debt: there are times when it is helpful, time when it is neutral, and times when it is negative: he asserts we are in the last zone.
He goes on to further assert that ‘the government expenditure multiplier is negative’ citing a few studies. In particular he cites Checherita2 finding a
non-linear impact of debt on growth … that may start from levels around 70-80% of GDP.
Mr. Hunt also argues that the negative real yields we have seen (until recently) argue that there is a high probability of a recession by looking at similar historical periods.
Mr. Hunt concludes by revisiting the simple aggregate supply and demand curves from Econ 101. I think this is useful to think through BOTH our inflation thesis as well as the longer-term effects of deglobalization.
He used the above chart to argue that the current environment is unlike the 1970s because the Fed will not be able to push out the aggregate demand curve as the velocity of money has collapsed.
In reviewing the chart for our purposes, we can see that all three of our proposed causes of inflation (covid, war, US labor) has the effect of moving the aggregate supply curve inward, moving the equilibrium points from A to B. The Federal government stimulus had the effect of shifting out the demand curve resulting in the equilibrium point moving to C. The question becomes, with the Fed embarking on tightening, how much (and for how long) does the AD curve shift back towards the left.
We can also think about this chart both globally and for the US/West alone. We’ve optimized on supply and demand globally, but the standalone graphs may be quite different. The US is a greater source of demand than supply (witness the trade deficit) so our standalone AS curve is to the left of the global curve. If the global supply went away tomorrow we would see GDP fall and prices rise, all else-equal (which it is not). At a minimum, it shows the headwinds we will face as we transition.
Lower Growth & Supply Shocks
Deglobalization at the margin reduces aggregate supply (real GDP) and increases price levels.
Demographics in the Western countries and China are headwinds to aggregate demand slowing GDP and putting little or no pressure on price levels.
Technological progress increases GDP and is deflationary.
In totality, relative to the recently earlier period of a rapidly growing China and increasing globalization, we should expect slower growth and at least less deflationary pressure (if not outright inflation).
This suggests two things to consider:
The lowering of growth not only lowers the average level of growth, but it likely shifts the entire distribution of outcomes. It would increase the probability of being in the binary state labeled ‘recession’ and could result in larger downside deviations.
Supply-side shocks could become more prevalent.
On this later point, see not only our earlier discussion of Zoltan Poszar’s work, but also the recent speech by Mark Carney3. In a speech devoted to the effects of climate change (the 2nd thing on the financial effects of climate change that I think is worth reading; both the economists and the climate folks in my audience will appreciate his charts) he writes:
the most important inflationary impact of the transition is that it constitutes a major supply shock that affects virtually every sector of the economy in every region. As Jean Pisani-Ferry points out, on a simple comparison it is on the same order of magnitude as the oil shocks of the 1970s which rendered large swathes of the economy uncompetitive.
Then, further, in a section titled ‘A World of Supply Shocks’ he writes:
The global economy is undergoing a series of major transitions with significant implications for macroeconomic policy and asset prices. The long era of low inflation, suppressed volatility, and easy financial conditions is ending. It is being replaced by more challenging macro dynamics in which supply shocks are as important as demand shocks, increasing inflation, volatility, interest rates and risk premia.
Just as globalisation was deflationary (Chart 12), its unwinding will be inflationary
Shocks to aggregate demand drive inflation and output in the same direction.
Things are different when shocks drive inflation up or down independently of demand. … Because monetary policy’s influence on inflation is predominantly indirect, via demand, in such circumstances inflation can only be controlled by causing a reduction in spending via higher interest rates.
Evidence
I generally prefer to look for information that challenges or refutes my initial hypothesis; this is where learning occurs, but I would be remiss if I didn’t share what I was coming across.
A recent paper4 in The Lancet has abundant statistics and projections on demographics. This chart I think represents things reasonably well (except it neglects Sub-Saharan Africa). It would be better if they graphed the projected dependency ratios.
And We Are Raising Rates
Further Things To Think About
What are the implications on the ‘financialization’ of the economy? Was this principally driven by dollar-recycling? I found this chart fascinating to think about, though not sure if it’s signal or noise.
Reinhart, Reinhart & Rogoff, Public Debt Overhangs: Advanced-Economy Episodes since 1800, Journal of Economic Perspectives Vol 26.
Checherita, Rother, The impact of high and growing government debt on economic growth: an empirical investigation for the euro area, European Central Bank: Working Paper Series: 1237
Carney, Climate Policy is Macro Policy, 2022 Volcker Lecture at NABE Conference