Why Those Looking for the Next Crisis May be Looking in the Wrong Places

Posted by Yves Smith – Naked Capitalism
Despite, or more accurately, because so many markets are at high levels, often on thin trading volumes, many investors are edgy. Even though markets famously climb a wall of worry, I can’t recall a time when there have been so many skeptical long investors.
For instance, even though the famed FAANG keep racing to even loftier levels, a US stock market crash would be unlikely to do a lot of damage. Unlike the 1929 crash, this rally isn’t fueled mainly by money borrowed from banks. And unlike the dot-com bust, speculative stocks are not being used as a form of payment. Recall that companies that should have known better, such as Lucent (this BTW was Carly Fiorina’s doing) and McKinsey were taking equity instead of cash, meaning as consideration for services. Informed insiders say McKinsey had to write off $200 million of stock it took in lieu of fees; the actual number may be higher given that McKinsey could have discounted its fees.

That practice was sufficiently widespread to give the dot-com crash a tad more sting than it might otherwise have had. Even so, there was no blowback to the payment system, and the early 2000s recession was not terrible by historical standards.
This is far from a complete list, but investors are worried about ETFs, Deutshe Bank, festering banking problems in Italy, and China’s debts, and a longer than usual list of exogenous risks, including nasty events resulting from increasing hostilities with North Korea, Russia, and Iran, perhaps a nuclear disaster resulting from wild weather, and further down the road, a disorderly Brexit doing more damage to Europe and it not-so-solid banks.
The reason this situation is so striking is that historically, crises that did real damage hurt financial institutions. In the Great Depression, banks all over the world failed, wiping out depositors’ funds, big chunks of the payment system, and the resulting downdraft correctly made the survivors too fearful to lend. In the US, a lot of traditional lending has been displaced by securitization, so investors taking losses or simply getting nervous could damage credit creation.
If one were to step back, and this is hardly a novel though, the root of investor nervousness is the sustained and extreme intervention by central banks all around the world in financial markets. No one in 2008 would have thought it conceivable that less than a decade later, one quarter of the world economy would have set negative policy interest rates. Even though markets only occasionally pay attention to fundamentals, sustained super low interest rates, by design, have sent asset prices of all kinds into nosebleed territory.
The Fed seemed to be the first to recognize that its monetary experiments had done little for the real economy, save allow for some additional spending via mortgage refis. It had done more to transfer income and wealth to the top 1%, and even more so to the top 0.1%, and enrich banks, all of which are hindrances to long-term growth. Yet Bernanke announced his intention to taper in 2014, and how far has the Fed gotten in getting back to normalcy? The answer is not very. And that’s because central bankers fear that their policies are asymmetrical: they can do more to dampen activity by increasing rates than they can to spur growth by lowering them. As we’ve repeatedly pointed out, businessmen do not go out and expand because money is on sale. They expand when they see commercial opportunity. The exception is in industries where the cost of money is one of the biggest costs of production…such as in financial services and levered speculation.
However, from what I can tell, the Fed’s desire to raise rates is driven by its perception that it need to have short term rates meaningfully higher, as in 2% or higher, so as to have room for cuts if the banking system gets wobbly. That is why it keeps treating a flaccid but less terrible than in the past labor market as robust.
But the potentially more interesting contradiction is in the posture of conservative businessmen. Higher interest rates will hurt their stock portfolios and the value of their homes. It will also hurt fracking, which is very dependent on borrowed money. Yet Republicans are more eager than Democrats to raise interest rates, apparently out of the misguided belief that low interest rates help labor, as opposed to capital (the Fed’s using the state of the labor market as its indicator as to whether to increase interest rates or not no doubt feeds this belief). Similarly, Republicans are far more exercised about the size of the Fed’s balance sheet and want it smaller. Again, there’s no logical reason for this move. The Fed’s assets will liquidate over time. They may not do much additional good sitting there (save the remittance payments back to the Treasury), but they aren’t doing any harm either.
In other words, the varying views about what to do about central bank interest rates and their holdings in many, too many, cases have to do with political aesthetics that often run counter to economic interests. A big reason that conservatives don’t like the Fed’s big balance sheet, even though the Fed is the stalwart friend of banks and investors, is that they still see the Fed as government, and government intervening in the economy offends them, even when it might benefit them. (Mind you, this is not the same as business exploiting government via “public private partnerships” or other approaches where commercial interests have their hand on the steering wheel).
Let me quote a seminal essay by Michal Kalecki, which even though it was written in 1943, sets forth the drivers of this line of thinking as well as anything I’ve seen since:
2. The above is a very crude and incomplete statement of the economic doctrine of full employment. But it is, I think, sufficient to acquaint the reader with the essence of the doctrine and so enable him to follow the subsequent discussion of the political problems involved in the achievement of full employment.
In should be first stated that, although most economists are now agreed that full employment may be achieved by government spending, this was by no means the case even in the recent past. Among the opposers of this doctrine there were (and still are) prominent so-called ‘economic experts’ closely connected with banking and industry. This suggests that there is a political background in the opposition to the full employment doctrine, even though the arguments advanced are economic. That is not to say that people who advance them do not believe in their economics, poor though this is. But obstinate ignorance is usually a manifestation of underlying political motives.
There are, however, even more direct indications that a first-class political issue is at stake here. In the great depression in the 1930s, big business consistently opposed experiments for increasing employment by government spending in all countries, except Nazi Germany. This was to be clearly seen in the USA (opposition to the New Deal), in France (the Blum experiment), and in Germany before Hitler. The attitude is not easy to explain. Clearly, higher output and employment benefit not only workers but entrepreneurs as well, because the latter’s profits rise. And the policy of full employment outlined above does not encroach upon profits because it does not involve any additional taxation. The entrepreneurs in the slump are longing for a boom; why do they not gladly accept the synthetic boom which the government is able to offer them? It is this difficult and fascinating question with which we intend to deal in this article.
The reasons for the opposition of the ‘industrial leaders’ to full employment achieved by government spending may be subdivided into three categories: (i) dislike of government interference in the problem of employment as such; (ii) dislike of the direction of government spending (public investment and subsidizing consumption); (iii) dislike of the social and political changes resulting from the maintenance of full employment. We shall examine each of these three categories of objections to the government expansion policy in detail.
2. We shall deal first with the reluctance of the ‘captains of industry’ to accept government intervention in the matter of employment. Every widening of state activity is looked upon by business with suspicion, but the creation of employment by government spending has a special aspect which makes the opposition particularly intense. Under a laissez-faire system the level of employment depends to a great extent on the so-called state of confidence. If this deteriorates, private investment declines, which results in a fall of output and employment (both directly and through the secondary effect of the fall in incomes upon consumption and investment). This gives the capitalists a powerful indirect control over government policy: everything which may shake the state of confidence must be carefully avoided because it would cause an economic crisis. But once the government learns the trick of increasing employment by its own purchases, this powerful controlling device loses its effectiveness. Hence budget deficits necessary to carry out government intervention must be regarded as perilous. The social function of the doctrine of ‘sound finance’ is to make the level of employment dependent on the state of confidence.
3. The dislike of business leaders for a government spending policy grows even more acute when they come to consider the objects on which the money would be spent: public investment and subsidizing mass consumption.
The economic principles of government intervention require that public investment should be confined to objects which do not compete with the equipment of private business (e.g. hospitals, schools, highways). Otherwise the profitability of private investment might be impaired, and the positive effect of public investment upon employment offset, by the negative effect of the decline in private investment. This conception suits the businessmen very well. But the scope for public investment of this type is rather narrow, and there is a danger that the government, in pursuing this policy, may eventually be tempted to nationalize transport or public utilities so as to gain a new sphere for investment.3
One might therefore expect business leaders and their experts to be more in favour of subsidising mass consumption (by means of family allowances, subsidies to keep down the prices of necessities, etc.) than of public investment; for by subsidizing consumption the government would not be embarking on any sort of enterprise. In practice, however, this is not the case. Indeed, subsidizing mass consumption is much more violently opposed by these experts than public investment. For here a moral principle of the highest importance is at stake. The fundamentals of capitalist ethics require that ‘you shall earn your bread in sweat’ — unless you happen to have private means.
4. We have considered the political reasons for the opposition to the policy of creating employment by government spending. But even if this opposition were overcome — as it may well be under the pressure of the masses — the maintenance of full employment would cause social and political changes which would give a new impetus to the opposition of the business leaders. Indeed, under a regime of permanent full employment, the ‘sack’ would cease to play its role as a ‘disciplinary measure. The social position of the boss would be undermined, and the self-assurance and class-consciousness of the working class would grow. Strikes for wage increases and improvements in conditions of work would create political tension. It is true that profits would be higher under a regime of full employment than they are on the average under laissez-faire, and even the rise in wage rates resulting from the stronger bargaining power of the workers is less likely to reduce profits than to increase prices, and thus adversely affects only the rentier interests. But ‘discipline in the factories’ and ‘political stability’ are more appreciated than profits by business leaders. Their class instinct tells them that lasting full employment is unsound from their point of view, and that unemployment is an integral part of the ‘normal’ capitalist system.
Notice the emphasis that Kalecki places on businesses preferring the “laissez-faire system,” meaning the market system, to create that essential elixir, “confidence”. We now have central banks for years not merely quietly and unobtrusively creating “sound money” in the background so that captains of industry can take credit for “confidence,” ten years after the start of the crisis, we still have central banks openly in the “confidence” game. That epitomizes why the outsized role of central banks so bothers conservatives. They see them as encroaching on their prerogatives even when the central banks are far more allied with the top economic strata, both culturally and by virtue of their main duty of keeping the banking system healthy, than with the great unwashed masses.
Now you might ask, how does this relate to the original question, that market mavens might be looking for the next crisis in all the wrong places?
The first is that despite widespread worries about a crisis, you don’t need to have a crisis to have a bubble deflate. In the runup to 2008, I expected the unwind of reckless lending spree to look like that of Japan’s. Japan’s joint commercial and residential real estate bubbles were much larger relative to the GDP than those in the US. Yet instead of a dramatic bust, the economy contracted like a car with no wheels banging down a steep slope. A mini-crisis of sorts did occur in 1997, when the authorities made the mistake of thinking the economy was strong enough to take some tightening, which kicked off a series of financial firm failures. So even if it turns out things do end badly, you can have the real economy suffer without having the financial system have a heart attack.
The second is that with some significant exceptions like Deutsche Bank, the authorities have succeeded in moving risk out of the financial system and more and more onto the backs of investors. That means the rich, but it also means pension funds, insurance companies, endowments, foundations, and sovereign wealth funds. Investors have already taken a toll via super low interest rates; economist Ed Kane estimated that in the US alone, that represented a $300 billion per annum subsidy to banks.
So even if we were to have something crisis-like, as in a sudden ratchet down in asset prices that stuck, it isn’t clear that the damage to critical financial plumbing would be significant.
That means the best guess, even with the ECB’s taper set to start this Thursday, that the effects of the crisis aftermath and any new upheaval are likely to create more instability in the political system and society, and that that may be more destabilizing than any immediate market/banking system impact. Admittedly, political times moves more slowly than financial time, so the authorities may congratulate themselves even as their ship has taken even more damage below the water line… 2017/10/23