Fischer Black and the business cycle

 

"Fluctuations in the match between resources and wants across many sectors create major fluctuations in output and unemployment, because moving resources from one sector to another is costly. Fluctuations in the demand for the services of durable goods causes much larger fluctuations in the output of durables, and causes unemployment that takes the form of temporary layoffs."

-Fisher Black 

Fischer Black focused on a general equilibrium business cycle long before other economists. As an academic and business practitioner, it is relevant to think about his model of the business cycle today in the context of disequilibrium across sectors. There are three potential sources of slowdown in the current economy: 

1. The pandemic 

2. Inflation 

3. Interest rates 

Each of these factors are causing disruptions which will play-out through a dislocation in labor, production, and purchases. During the GFC, the sector disruptions between housing and banking were significant. The current disruptions are not as strong and not as focused. The reason for the delay in this adjustment process is the strong fiscal and monetary policy already applied during the pandemic which has cushioned the downward shock. 

The impact of the pandemic is being felt now in the technology sector. Over investment in technology associated with being shut-in is being reassessed and layoffs are occurring. The reason it has not shown in the data is that these companies are not very labor intensive. We are seeing adjustments in the delivery sector as less is being purchased on-line. Additionally, switches into green markets are creating churn with traditional sectors. 

Inflation is causing disequilibrium across sectors because of pricing distortions. Purchasing mistakes are being made. Real wealth is being adjusted which changes purchasing patterns and generates further economic churn.

The rise in interest rates is creating distortion across markets sectors. Clearly, the housing sector has been hit hard. The IPO market has also been hit given the cost of capital has increased. Higher rates are reducing the reach for yield. 

So why has there not been a recession? The disequilibrium adjustments are taking time, against a background of government fiscal and monetary support. 

The important takeaway from a Fischer Black view of the world is that the focus must be on distortion in the economy across sectors. The sum of distortions leads to an aggregate slowdown, but there is a lot of potential opportunities focusing on the disaggregated effect of the economy. Government policies can slow the impact from disequilibrium economics, but it cannot eliminate it. Watch for growing sector distortions as a driver for aggregate distortions. 

Kindleberger cycle and current bubble markets

 

There is a lot of talk about bubbles and manias especially with respect to blockchain and cryptocurrencies. There has been a lot of hype and it is likely that many of the dreams associated with this technology will either never be realized or only realized in the more distant future; nevertheless, bubbles may have a social good because it funnels capital to new technologies. 

New technologies that are given capital can lead to increased productivity and provide a positive social and economy good. This may not be the best way to fund new technology because there will be damage when a bubble burst, but it is worth considering how bubble cycles can be an engine for growth. See KINDLEBERGER CYCLES: METHOD IN THE MADNESS OF CROWDS? by Randall Morck 

There are positive externalities from bubbles and manias that will provide an engine for growth. Perhaps some of the bubble with EV and green technology will be the driver for elevated productivity and enhanced growth? Productivity and growth are not just the mixing of capital and labor. There often needs to be a catalyst to provide a spark for growth.  

Stagflation and debt traps - The twin problems that are not going away

 

Nouriel Roubini - "we are facing a stagflation and debt trap." 

Professor Roubini is known to many as a Dr Doom, but he has proven to be good at framing the problems we face. The timing may be off on when these traps will bind investors, but there will have to be a day of reckoning. 

We have been facing a debt problem since before the GFC. Overall debt was high prior to the GFC. After the GFC, households retrenched, governments did not, and corporations used low rates to lever their balance sheets. This was not an issue when at the zero bound but times are different. In a rising market environment, debt was not an immediate problem. Debt was matched by higher asset values and growing wealth; however, with at best a stall in wealth, balance sheets are deteriorating as debt burdens increase.

Stagflation only makes the debt situation more precarious. Inflation is good for debtors. Think of all the negative debt that was destroyed as rates moved to positive. Yet, new debt and existing debt that must be rolled-over will be at higher rates, and the stagnation in growth diminishes the ability of households and firms to pay-down this higher rate debt. Government debt is not immune to stagflation, but increases in inflation support higher tax revenues. 

Of course, these are generalization and that in of itself is a problem. Inflation and low growth create uncertainty and ambiguity of what prices will rise and what will remain stable. Low growth reduces potential new investments. Firms will fail. Firms will not invest, and households will change their spending patterns.

Monetary policy should be restrictive to reduce inflation, but raising rates only enhances the debt problem. Funding costs increase which increase defaults and bankruptcies; however, relieving the debt problem will prolong the inflation problem. A solution to one trap supports the other problem trap. Neither can be solved.  

Debt coupled with stagflation create a negative feedback loop. More of either will extend both  problems.

Rereading Kindleberger - Institutions Matter

 

With a new book by Perry Mehrling, Money and Empire: Charles P. Kindleberger and the Dollar System, the interest in Kindleberger's writing and thinking should increase. Of course, most remember him for his work on speculation, Manias, Panics, and Crashes (1978), but he was deep thinker on economic history and the role institutions to affect policies. In an era of mathematical modeling, Kindleberger was a throwback to a different period when looking at institutional structures provided clarity on how market worked or failed. 

He wrote an important history of the Great Depression which is often lost to other works that attempt cast the Depression through a specific economic model lens. He wrote with clarity about the events leading to the Great Depression without a strong bias. It was not a monetarist or Keynesian problem but one based on the failure of policy, foresight, and institutions. 

Kindleberger wrote about the life cycle of nations and the importance of institutional arrangements for well-functioning markets. This was done through digging into the history and not through model abstractions. 

Of course, we need models, but we also need deep institutional analysis to look beyond models and decipher why market failures may exist. To place Kindleberger in context, institutional arrangements matter whether for panic and crashes or policy success and failure. 

Some great Kindleberger quotes plucked by Mehrling for his book,

“The model for the world should be the integrated financial market of a single country, with one money, [and] free movements of capital at long and short term.”

“When markets don’t work, don’t use markets.”

“Governments propose, markets dispose.”