Why We Need a Recession

Interest rates and their long term effects on capital and consumption

It's fairly well understood that a regime of steadily falling interest rates is bullish for stocks.

The chart below (click to enlarge images) shows that long rates have been falling more or less steadily since the mid-1980s.

A long term DOW chart (borrowed from here) shows its response to this steady lowering of rates:

In spite of some violent corrections, we saw steadily rising stock prices for an extended period starting in the mid-1980s. Rates are now at or near historic lows.

Over the course of this 25-year rate reduction, the DOW reached historic highs but it has since stumbled, and has thus far failed to respond to further lowering of interest rates. The conventional wisdom is that interest rates need to be lowered even further in order to reignite lending and economic activity. The Federal Reserve has even taken the position that “effective” rates need to be reduced below zero by “quantitative easing”, injecting brand new money born from aether.

This period in the West especially has been characterized by a global shopping spree of historic proportions. Savings rates plummeted and consumption was king. The percent of US GDP that is attributed to consumption has grown almost steadily, from 64% of GDP in 1981 to a peak of 72% of GDP in 2007. What effect has this had on capital formation? How do interest rates influence this?

Capital, in my view, is saved work; it is excess production that is not immediately consumed. Saved work in the form of capital can be loaned out and used to begin another productive process. Consumption, on the other hand, renders the saved work “no longer available for lending”. Certainly, consumption and savings are both vital parts of any economy. Trouble ensues when these two forces become unbalanced and insufficient savings are fed back into the system.

Interest rates influence behavior. High rates of interest encourage savings, while low rates of interest encourage consumption. The regime of steadily falling interest rates tipped the balance of consumption / savings too far in the direction of consumption.

Evidence of this can be seen everywhere. Savings rates in the US reached all time lows, and for a time were negative. Our trade deficit and national deficit indicate our zeal for borrowing to consume. We borrowed money from anyone who would lend it to us so we could buy everything in sight. We borrowed this money from foreign savers. In effect, we borrowed their saved work (capital) and consumed it. Thanks, Asia!

Evidence of excess consumption is similarly easy to find in America: glitz was the only thing that mattered, the glitzier the better. We bought everything we wanted and couldn’t afford: not just a house but a McMansion, not just a TV but a 50 inch flat screen, not just a car but a Hummer…it is obvious and everywhere. We lived a drunken party. The party was aided by government policy (“deficits don’t matter”) and abetted by the easy money Greenspan Fed. A sociologist could also easily indulge in a diatribe about the effect this has had on American culture. That is for another day.

What happened to global capital during this time? We ate it; it’s gone. Whatever might have been leftover is being revalued by economic contraction and destroyed by government action. How does government action destroy capital? The government is going to “recapitalize the banks” by “injecting them” with “new capital”. Where is this “new capital” coming from? Why, it’s coming from a printing press in the basement of the Fed (and, I might add, without either the approval of Congress or sanction within existing law).

At the same time, the Fed is further discouraging savings by lowering interest rates to try to reignite personal borrowing for consumption, while the Treasury borrows still more money from foreign savers in its latest installment of “Pay you next Tuesday for a hamburger today.”

These are exactly the opposite of what is needed. Savings must be encouraged. Capital cannot be printed, nor can it be clicked into existence, the modern equivalent of the printing press. Efforts to print capital merely dilute any capital that may still exist. Lower interest rates will not encourage the saving of real capital. Printing money and calling it “capital” will merely debase the currency, leading to inflation. Finally, higher debt levels will not add to GDP due to the reduced marginal utility of debt.

Borrowing our way to prosperity: "The Marginal Utility of Debt"

This article (pdf warning) includes a chart titled "The Marginal Utility of Debt in Real Terms" which shows that, over time, new dollars of debt have much less of a stimulative impact on the economy than earlier dollars of debt. A quote from that paper sums up the chart nicely: “In the 1960s, real total debt outstanding in the U.S. ‘bought’ $0.64 in additional real GDP. In the current decade, a dollar of real additional debt now ‘buys’ $0.15 in additional real GDP.” What is the reason for this gradual reduction in the marginal utility of debt? I want to suggest that the reason might be capital destruction due to a regime of steadily lowering interest rates. We may in essence be at the end of a credit super-cycle that carries a component of capital destruction.

According to Antal Fekete, a regime of falling interest rates destroys capital. Certainly, a regime of falling interest rates biases the balance of savings/consumption ever towards consumption. In such an environment, where does capital come from? It comes from foreign savers, or from nowhere at all. Higher interest rates encourage savings over consumption and hence are supportive of capital and thence capital formation. The high interest rates of the early 1980s encouraged capital formation and established the capital base for a new productive economy. A recession was the necessary impetus for this increase in savings.

The recession impetus is twofold: one, it scares people into favoring saving over consumption, bringing the two back into balance; two, it encourages savings by rewarding savers with higher returns. Over time, since the 1980s, we have continually lowered interest rates to try to avoid adjustments (recessions), but we have had to do so more and more due to the gradually reducing marginal utility of debt. We have now reached the end of the cycle.

What does this predict for our future? In my opinion remaining capital is inadequate and must be replenished by savings. THIS MEANS THE RECESSION IS NECESSARY.

The Fed will continue its reinflation campaign and will cause a currency crisis similar to that which occurred in the 70s when Nixon took the US off convertibility. We will then endure a bout of inflation and inflate away some of the old debt; everyone's lifestyles will be reduced for a time to pay for that part of the debt we don’t inflate away; we'll raise interest rates and begin to save real capital so that we can restart the process.

Put another way, the conclusion I draw is that we need to "reset" or “rebalance” the productive economy. Ultimately it will look like we raised interest rates to suppress inflation (still to come) and support the currency, but what we really will have done is to re-enable savings and make capital formation possible again.

It should be obvious by now that the business cycle is alive and well. This means that the existence of the Federal Reserve has done nothing to do away with the business cycle. In contrast, the Fed’s action of constantly lowering rates in response to slowdowns destroys capital and ensures deeper and more destructive slowdowns. Having a Fed is worse than having no central bank at all.

In the best case, the recession must come, and there will be a long period of zero or low economic growth and flat stock markets; the time required for this recession to play out, in my opinion, is determined by the size of the capital deficit that must be replenished and the excess debt that must be repaid. Draw your own conclusions about how long that might be. In the meantime we run the risk of a currency crisis caused by quantitative easing and the further risk of another economic black swan or geopolitical event causing a full blown panic.

This provides a backdrop for the coming “mother of all reinflation attempts”: a coordinated fiscal stimulus / monetary stimulus / public relations campaign with Obama starring in the lead role. That’s also a subject for another day.

Disclosure: Long PMs / short dollar. I am not a professional economist or money manager. DYODD.

Comments

[Asbytec:]

Agreed, totally. We need to reboot our economy and deleverage. It's painful, but necessary.

Jan 08 09:19 AM

[axelrod608:]

Excellent article. I especially liked your line - >> "What happened to global capital during this time? We ate it; it’s gone" >>

And the "marginal utility of debt" concept is so important in a climate of gummint insistence of reinflating the debt producing bubble that got us into this mess.

Listening to Obama's speech a few minutes ago reinforced my opinion that the only CHANGE will be the names on the doors and desks. The next batch of "leaders" thinks exactly the same way, using the same underlying assumptions as the outgoing ones.

Keep your powder dry, your stops tight and your seatbelt fastened - we're in for a bumpy ride.

Jan 08 12:14 PM

[blinkmnt:]

If we add to all of that the quantity of leveraged money out there from the ex-investment bankers, the scenario is even worse

Jan 08 12:19 PM

[prudentinve...:]

Excellent article.

However, it seems that fed does not wish to acknowledge reality of business cycles, and necessity of recessions in a market economy.

Rather, they are determined to keep on pumping liquidity, using experimental and untested methods, in the hope of further postponing the necessary economic adjustment.

In a healthy economy, people spend the value of their own labor rather than spend money borrowed against assets. We need to realize that the experiment of trying to construct an asset-based economy to replace the traditional labor-based economy has failed, just like it failed in Japan two decades ago.

Jan 08 02:13 PM

[SW Richmond:]

Thank you all for your comments.

prudentinvestor,

My belief in the Fed's course is cemented in place by the very existence of the Fed. They cannot do nothing, even though doing nothing would cause the least harm, simply because doing nothing would be an admission of their impotence. Since under "normal" times the Fed provides the inflationary funding vehicle for expansionary government and banker mischief, such an admission is a virtual impossibility. They MUST try to reinflate; no other course is possible. The issue is political and not financial.

By the way, if you haven't seen it, this interview with Bill Poole is a must-watch.
www.bloomberg.com/avp/...

Jan 08 05:24 PM

[prudentinve...:]

Thanks for posting this link.

While confessing that I am unqualified in legal and constitutional matters, I must say that it appears that the fed is stepping into social policy and international politics that should be the prerogatives of congress and the executive branch.

After all, the social policy aspect of picking winners and losers within society, as to whose mortgage gets subsidized by whom, and whose mortgage does not, seems like the prerogative of the legislative branch. Similarly, extreme monetization could affect international relations with our creditors, and this issue seems like the prerogative of the executive branch, perhaps the state department.

should be dealt


On Jan 08 05:24 PM SW Richmond wrote:

> Thank you all for your comments.
>
> prudentinvestor,
>
> My belief in the Fed's course is cemented in place by the very existence
> of the Fed. They cannot do nothing, even though doing nothing would
> cause the least harm, simply because doing nothing would be an admission
> of their impotence. Since under "normal" times the Fed provides the
> inflationary funding vehicle for expansionary government and banker
> mischief, such an admission is a virtual impossibility. They MUST
> try to reinflate; no other course is possible. The issue is political
> and not financial.
>
> By the way, if you haven't seen it, this interview with Bill Poole
> is a must-watch.
> www.bloomberg.com/avp/...

Jan 08 08:37 PM

[Gisi:]

Your article makes a very good point and I especially agree with your last comment regarding the Fed's obligation to interfere. However, this ultimately goes back to the underlying problems in American capitalism. The recession is not only necessary to move us through the economic cycle but also to, in a way, reinvent American values. A sort of a call back to reality.

I think it's absolutely ridiculous, for example, that as the price of gas increased, Americans become enamored with hybrid cars and saving the environment. Then gas prices dropped and now consumers welcome back with open arms those unnecessarily large SUVs (though clearly not enough for the Big Three). This just goes to show that Americans DON'T believe in saving money. They want to spend every bit they have and a lot of what they don't have if they can get their hands on it. What I'm seeing now is two extremes: one causing the economic meltdown and the other prolonging it.

What we really need is to encourage saving everyday, not only in emergencies. As the saying goes, buy an umbrella on a rainy day.

Jan 08 08:54 PM

[SW Richmond:]

Gisi,

As I alluded to in the article, I believe that the easy money policy brought out the worst in us by enabling us to become self-indulgent. If you study history you notice that people adapt to prevalent conditions after only a few years of their existing; it seems to take those few years for paradigms to be broken and new ones accepted. Two and a half decades of easy money made us think life was easy and it was time to have fun and enjoy it. Few of us remained skeptical and didn't over-indulged, but those of us remained skeptical were the first to see the trouble brewing.

I doubt any other nation or people would have maintained their sanity through 25 years of "easy money, anything goes".

The "stock market magic" paradigm is still alive in spite of much evidence that it should be dead; people can't wait for an excuse to get back into the stock market and get back to easy money. The other prevalent paradigm right now is the "US Dollar and US Treasury safe haven" play. These too will die, but it will take time. My next article will probably be about paradigms.

Jan 08 11:36 PM

[ArtfulDodger:]

Too much debt is what got the nation (and the world) into this mess, yet every day government leaders encourage citizens to take on even more debt "to restart the econmy."

They also encourage lending institutions to crank up the lending again, although that's what got them in the trouble they're in.

How can we save the nation with leaders such as these?

We may not go the way of fallen empires immediately.

But how long can it be before we become as these great empires of the past: the Egyptian, Assyrian, Babylonian, Hittite, Troy, Hellenic, Israelite, Karthaginian, Tuscan, Roman, Hapsburg, Dutch, Persian, Viking, Spanish, Ottoman, French, Romanov, English.

The above empires fell to varying degrees: some gone forever, some remain a partial of their greatness. None is considered great today.

They also fell for varying reasons: spreading themselves too thin around the world, to printing fiat money, to defeat in wars, to wide open borders, to a huge underclass that could not produce.

But each one has some similarity to the mighty USA.

How long can it be?

Feb 22 03:21 AM