Bear Eats Sheep
The standard argument following the American financial crisis of 2008 was that no one could have foreseen the process. It was considered to be an unexpected event probably driven by a lack of regulation and too much greed. However, not only were there some who did see the crisis years ahead of time, the Federal Reserve responded to the chatter by denying the existence of a housing bubble as it was unfolding. For example, a paper published by the Federal Reserve Bank of New York in 2004 stated that, “Our analysis of the U.S. housing market in recent years finds little evidence to support the existence of a national home price bubble.” (McCarthy & Peach, 2004). Two years later, at the height of the bubble, the Federal Reserve Bank of Philadelphia published another paper which concluded that the “rise in house prices over the past 10 years can be explained mainly by fundamental factors, namely, rising income and falling interest rates.” (Schiller, 2006). Yet, simply because most economists were either oblivious to or wrong about the housing bubble, as was the case with the dotcom bubble prior to the housing bubble, does not automatically mean that macroeconomic forecasting is impossible or even difficult.
The present state of the economy is a mixed one. On the one hand, GDP has been growing since mid-2009 and unemployment has been falling since 2010. One the other hand, it wouldn’t be a stretch to say that the current state of affairs feels like a malaise, with long-term unemployment remaining stubbornly high and median incomes stagnating. There are some peculiar arguments for why the economy will continue to grow and why the stock market should continue to rise in 2015. For example, earlier this year technical analyst Louise Yamada stated that the “one positive, of course, is that 2015, as a year ending in 5, has a very good record of being an up year” (Yamada, 2014). Yet, according to the National Bureau of Economic Research, there have been 33 recessions in the US since 1857. This means that, on average, the US has had a recession every 4.8 years (NBER, 2014). However, the future is not a mere subject of extrapolation. Forecasting the future, to the extent that it is possible, is primarily a matter of reason and not statistical alchemy (Keynes, 1940).
One of the reasons why Wall Street and academia have by and large failed to see the past two crises is because their modelling of risk is focused on moderate probability, i.e., on the assumption that black swans do not exist. They attempt to determine the bandwidth of outcomes on a given probability, say 95%. The various value at risk (VaR) systems that the boys at the Fed and Wall Street have cooked up are fundamentally wrong when it comes to risk management, but it nevertheless remains popular partly because statisticians, playing the role of risk managers, are good at generating and running these systems. In the 1990s, a hedge fund called Long-Term Capital Management (LTCM), which ironically went bankrupt in a short amount of time due to capital mismanagement, found this out the hard way. Spearheaded by Nobel Laureates Myron Scholes and Robert Merton, the strategy of LTCM was based largely on regression analysis. The underlying idea was that spreads would regress toward their historical averages, thus if the spreads were far from their historical averages a profit opportunity would emerge. This assumption worked until 1998, when market spreads, instead of converging, started to violently diverge. Since the operations of LTCM were heavily leveraged, the hedge fund went kaput. Ultimately, the hedge fund went under because they were driving while looking in the rear view mirror, albeit a fancy one.
The Maestro (Not Greenspan)
Richard Cantillon was one of the most interesting figures when it comes to economic thought. William Stanley Jevons considered Cantillon’s work, Essai, first published in 1755, to be the “Cradle of Political Economy” (Jevons, 1881). Cantillon became a multimillionaire leading up to 1720 as a participant in both the Mississippi bubble which took place in France under the direction of John Law and the South Sea bubble which simultaneously took place in Great Britain[1]. In short, Cantillon put his ideas of monetary theory to the test and made a fortune by selling out before the devil took the hindmost. What is puzzling is that this man, who came before Adam Smith, is hardly ever mentioned, even in economic or investing circles.
Richard Cantillon was born during the 1680s in County Kerry, Ireland. During his 20s, Cantillon moved to Paris, where he managed to attain French citizenship (Brewer, 1992). In Paris, Cantillon would go on to become a successful banker, specializing in money flows between Paris and London. After the bursting of John Law’s Mississippi scheme, Richard Cantillon moved to London. There were many resentful lawsuits filed against him by his debtors, many of whom were financially ruined because they hung on too long and used leverage. In 1734, Cantillon’s residence was burned to the ground and it was assumed that Cantillon died in the flames, although some would suggest that Cantillon staged his death in order to escape his resentful debtors (Murphy, 1987). It’s possible that Cantillon had a stalker named Chevalier de Louvigny, or that he assumed this name after presumably dying in a fire.
Through the likes of Lord Bolingbroke, Richard Cantillon crossed paths with many of the leading intellectuals of his time, including Montesquieu and Voltaire. Moreover, Cantillon was not shy in critically engaging the geniuses of his time. As an example, Sir Isaac Newton was, amongst other things, director of the Royal Mint[2]. Great Britain was, at the time, on a bimetallic standard consisting of silver and gold. Having understood what is now known as Gresham’s law, Cantillon correctly warned Sir Isaac Newton that his overvaluation of silver relative to gold would drive silver out of circulation. It is apparent throughout the Essai that Cantillon had a deep understanding of many economic concepts, some of which did not even have a name yet. These would include the concept of opportunity cost and the capital asset pricing model (CAPM). Cantillon was also, in numerous regards, the father of various sub-branches within economics. For example, he paved the way for the field of spatial economics (Hébert, 1985). Another one of Cantillon’s contributions to economics is the use of thought experiments in the form of ceteris paribus, i.e., assuming all other things equal. As an example, we cannot say that an increase in the supply of money and credit will lead to consumer or asset price inflation. However, we may very well say that an increase in the supply of money and credit will raise prices (or prevent them from falling) more than would otherwise be the case. Thus, by starting with the basic laws of supply and demand, we know that an increase in the supply of money is, ceteris paribus, inflationary, even if a particular dataset would show that prices were falling during a period of increasing money supply (e.g., during the Great Depression).
Richard Cantillon took the view that property owners play the crucial decision making role when it comes to consumption, production, and population size. Cantillon did not place value judgments on his claims, which is quite common amongst economists to this day. Rather, Cantillon sought to describe things as they were. As an example, Cantillon considered the issue of whether a country ought to have a large but poor population versus a small but wealthy one to be outside of the purview of economics. In his view, economics was not about whether a policy or a set of policies was good, well-intentioned, or in accord with his own ideology but rather whether the means could achieve the ends. This scientific versus ideological reasoning allowed Cantillon to see that neither the Mississippi nor the South Sea bubbles were sustainable.
The world that Richard Cantillon portrayed in his Essai is essentially trickle down. For example, he wrote that “the largest property owners in the state reside in the capital; the king or supreme government is established in it and spends the government’s revenues there; the supreme courts of justice are located there; it is the center of the fashions, which all the provinces take as their model; and the property owners, who reside in the provinces, occasionally spend time in the capital, and they send their children there to be educated. Therefore, all the lands in the state contribute, more or less, to maintain those who dwell in the capital.” (Cantillon, 2010, p. 39). He would go on to add that “everything in a state depends mainly on the moods, modes, and ways of life of the property owners” (Cantillon, 2010, p. 71). As an elaboration he would add that “many workers do not work directly for the property owners, and so it is not seen that they subsist on the capital of these proprietors and live at their expense” (Cantillon, 2010, p. 71). Labor, in the world that Cantillon describes is analogous to pilot fish, which congregate around a shark and eat the leftovers. Yet, Cantillon does not make the assertion that property owners are destined to remain so, nor that the property-less are destined to remain so.
The Future
I: Affluent Spending
The point of bringing up the ideas of Richard Cantillon is not to examine whether they are politically correct but whether they have some semblance of truth to them. After all, this was a man who apparently understood how the world worked, having profited greatly from two historic bubbles while the majority of participants got swept up in euphoria, delusion, and new era thinking. Based on the ideas of Cantillon, it should be the case that the relatively affluent dictate the pace and direction of economic activity. In terms of contemporary international finance, the saying that when the US sneezes the world catches a cold would suit Cantillon well.
One indicator which seems to bear out the trickle down logic of economic activity is Sotheby’s stock (NYSE:BID). As shown below, it tends to peak before any major crisis, including the Japanese real estate bubble of the 1990s, the dotcom bubble of 2000, the American financial crisis of 2008, and as of late 2013 it has once again started to decline. The assumption is that when the rich spend record setting sums on con–temporary art, not only do those proceeds trickle down, but the rich are likely to be spending more in general. Alternatively, when the rich start to decrease their purchases of con–temporary art, there are less proceeds which trickle down.
(Yahoo)
As a result of less money trickling down, consumers seem to smell trouble ahead of time prior to a recession. In other words, consumers negatively react to the decreased spending of the affluent, and in turn decrease their own spending. It is worth mentioning that, internationally speaking, the US consumer is a sort of affluent spender itself. When the wealthy US consumer starts to decrease its spending, the lower socioeconomic groups on the pyramid in turn start to decrease theirs; call it a feedback loop.
(FRED)
If Cantillon’s idea that the relatively poor feed on and are sustained by the rich is correct, then we should expect the amount of people who voluntarily leave their jobs in exchange for leisure to rise in good times. This is so because people feel relaxed and comfortable in relatively good times when the property owners are trickling down a lot of wealth. The presumption is that, if the case need be, the job will be there later on anyway. Therefore, we should expect the amount of people who voluntarily leave their jobs to decrease leading up to and during a recession, since there is less wealth trickling down. The data seems to bear this out, as the percentage of job leavers as a percent of total unemployed does in fact tend to fall leading up to and during a recession.
(FRED)
“No one is satisfied with even exorbitant gains, but every one thirsts for more, and all this founded upon the machine of paper credit supported only by imagination.” – Edward Harley, 1720
II: Asset Prices
When it comes to the supply of money and credit, Cantillon’s central contribution was the non-neutrality of money. Cantillon used process analysis in order to discern the effects of inflation. An increase in the supply of money will tend to push up demand, which will in turn push up the prices of those goods, assets, or services subjected to the increase in demand. Moreover, an increase in the supply of money will affect interest rates differently depending on how that money is injected into the economy. If the money goes through the banking system, then interest rates are likely to fall while asset prices should rise relative to consumer prices. If, on the other hand, the money enters the economy directly, then interest rates are likely to rise while asset prices should fall relative to consumer prices. In a nutshell, money and credit inflation represented a sort of redistribution from those who receive the money later on after prices have already risen to those who are relatively first in line to receive and spend the new funds. Hence, Cantillon made the subtle but crucial point that interest rates are determined not by the supply and demand for money but rather by the supply and demand for loanable funds.
With regard to monetary inflation and interest rates, Richard Cantillon was truly well ahead of his time. In fact, the Essai may be considered to be a precursor to other thinkers such as Knut Wicksell (Wicksell, 1936), Ludwig von Mises (Mises, 2009), and Hyman Minsky (Minsky, 1982), all of whom placed emphasis on how monetary inflation affects the period of provision, i.e., the structure of production. As put by Cantillon, an “abundance of fictitious and imaginary money causes the same disadvantages as an increase of real money in circulation by raising the price of land and labor, or by changing the value of money and goods only to cause subsequent losses. This furtive or unnatural abundance vanishes at the first gust of scandal and precipitates economic chaos” (Cantillon, 2010, p. 235).
The data does seem to bear out the assertions made by Richard Cantillon centuries ago. For one, the increase in the supply of money and credit since the American financial crisis has gone through the banking system and has been deliberately channeled into the stock market. “Helicopter Ben” has in fact been “Wealth Effect Ben”. This should have, at least according to Cantillon, pushed down interest rates and pushed up asset prices relative to consumer prices. In fact, this is exactly what we see today. Interest rates are at historic lows while asset prices are at historic highs. The chart below shows the Wilshire 5000 Total Market Index, which measures the performance of all US stocks with readily available price data.
(FRED)
Despite the bursting of the dotcom bubble in 2000 and the American financial crisis of 2008, the US economy continues to march forward like the Great Western Railway locomotive on a Turner painting. This has certainly been the case thus far, at least under the surface. However, a large part of this is due to the money illusion (Fisher, 1928). The chart below shows the same Wilshire 5000 Total Market Index adjusted for inflation. It wasn’t until 2013 that the index was able to breach the peak achieved in 2000, and the rise since appears to be quite artificial.
(FRED)
Moreover, relative to oil prices, the stock market has declined substantially since 1999. The chart below shows the Wilshire 5000 Total Market Index divided by the price of West Texas Intermediate (WTI) crude oil. This drastic decline is due to a combination of oil prices having bottomed out in late 1998, having risen in real terms ever since, and stocks not having done so great adjusted for inflation since the bursting of the dotcom bubble in 2000.
(FRED)
While at first oil prices may seem irrelevant, they are anything but. Whether or not Janet Yellen decides to raise interest rates in order to halt speculation, which seems unlikely, an oil price spike will not fail to induce another recession via demand destruction. The reason for this is that rising real oil prices act as a sort of tax. The more the consumer pays at the pump, the less discretionary income they have left over. While this logic may apply to other goods or services, gasoline and diesel possess a unique mix of relatively high energy density on a per unit volume and per unit mass basis, making these fuels hard to economically substitute for cars and trucks. Moreover, the transportation infrastructure revolves around oil, which is something that can only be altered incrementally over long periods of time. Today, gasoline prices are already near the peak which was reached shortly before the onset of the American financial crisis. The chart below shows the price of gasoline, as tracked by the New York Mercantile Exchange.
(Trading Economics)
“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” — John Maynard Keynes
III: Valuations
It may be the case that things continue to muddle along, provided oil prices remain flat or rise in a slow fashion. Like a boiling frog, if oil prices rise slowly, Mr. Market could remain bullish without noticing anything peculiar. On the other hand, if oil prices start to spike from an already elevated position, Mr. Market is destined to jump out in panic. Unlike margin debt, which can be manufactured via financial institutions ex nihilo, oil is a scarce resource. There is no doubt that the stock market today is overvalued. The chart below shows the cyclically adjusted price-to-earnings (CAPE) ratio for the S&P 500. The CAPE was developed by Nobel Prize-winning economist Robert Shiller and was designed for the purpose of measuring whether the stock market is overvalued. Today, the S&P 500 CAPE stands at 26.64, meaning Mr. Market is willing to pay nearly 27 times the price for the earnings of the S&P 500 on a cyclically adjusted (10-year moving average) basis. Historically, there were only three other occasions on which Mr. Market was willing to pay more than 25 times earnings, (1) 1929 shortly preceding the crash, (2) in the mid-1990s preceding the bursting of the dotcom bubble, and (3) starting in 2003 preceding the American financial crisis.
(multpl)
Today, the junk bond market is akin to the subprime market leading up to the bursting of the housing bubble. Subprime mortgages, many of which were financed via NINJA loans, were treated and to a large degree rated as AAA securities after being bundled as collateralized debt obligations (CDOs). Since the American financial crisis, junk bonds (bonds rated BB or below) have performed exceptionally well, as if there were no risk associated with them. Like the pilot fish feeding on the shark, the subprime bubble was a by-product of a larger bubble in real estate. The current bubble in junk bonds seems to be a by-product of a larger bubble in corporate and government bonds. As put by Robert Shiller, “The current combination of exceptionally low yields and high prices suggests that much of the world is in a bond-market bubble, and when it bursts in coming years, a period of higher long-term interest rates and lower long-term bond prices will follow.” (Shiller, 2003). The chart below shows how junk bonds have performed relative to the Dow Jones Industrial Average along with volatility (VIX), which is at historic lows, indicating complacency.
(FRED)
While there certainly is a lot of talk about record high corporate profits, what is less talked about is the runaway ballooning hyperinflation of corporate debt.
(FRED)
In fact, the corporate debt-to-GDP ratio is at an all-time high, up from less than 13% in 1980 to more than 24% today.
(FRED)
Moreover, per the chart below, the stock market capitalization is 1.2 times GDP. Previously, the stock market capitalization has surpassed GDP on only two occasions: during the late 90s leading up to the dotcom bubble and in late 2006 leading up to the housing bubble. Far from being a safe haven, US equities are overpriced by virtually any metric.
(FRED)
During the housing bubble, subprime loans were pooled into collateralized debt obligations (CDOs), which would in theory reduce risk by diversifying the income streams from just one risky lender to potentially thousands. Today, low-rated corporate loans are being pooled into collateralized loan obligations (CLOs), which should reduce risk in a likewise fashion. Needless to say, CLOs have been growing at an unsustainable pace.
Another bubble which is of macroeconomic importance can be found in tertiary education. From roughly $150 billion in 2009, the federal student loan bubble has risen in a parabolic fashion all the way to $770 billion as of April 2014. More importantly, this does not include all the tertiary loans which have been taken out from private institutions. The simple answer to why higher education costs have been running out of control is because there has been a tremendous amount of credit thrown at the industry. One sign that this bubble cannot go on forever is the increasing amount borrowers failing to meet their payments on time.
(FRED)
There are also numerous international pressures which can, in part, trigger another worldwide recession. The structural imbalances caused by the euro, which amounts to an invisible currency peg amongst 18 states, has continued to exacerbate the fiscal deterioration of Portugal, Italy, Greece, and Spain (PIGS), all of whom have a higher debt-to-GDP ratio today than was the case during the eurozone crisis. This process was predicted by economists Wynne Godley and Marc Lavoie (Godley & Lavoie, 2006). With regards to China, it’s no secret that real estate prices are grossly overvalued relative to incomes, even when compared with the Japanese peak in 1990 and the US peak in 2006 (Fawley & Wen, 2013). Furthermore, it is not just China which has a real estate bubble brewing, but numerous other countries like Norway, Brazil, and Sweden. Moreover, any meaningful escalation of the numerous conflicts revolving around the Sunni-Shia divide, a divide which spans well over a millennium, taking place throughout the Middle East, has the potential to send oil prices soaring.
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