What makes the present situation, despite the still solid economic growth in the US, so dangerous is that markets focus on equilibrium restoring mechanisms and tend to ignore (or have complete blind spots for) self-reinforcing ones.
This is a residue of the 19th century mechanical approach (imported from science) of equilibrium economics in which free price movements equate demand and supply and restores market equilibrium. Economics knows of several exceptions:
- Location: the economics of agglomeration making strong regions stronger because of agglomeration effects (basically external economies of scope and scale).
- Network effects, in which the value of networks increases to the square of the number of users according to Metcalfe Law.
There are also at least two of these self-reinforcing mechanisms that can worsen slumps:
- The Keynesian multiplier, where a reduction of spending leads to less income for others, which reduce spending as well causing a ripple effect (which still dampens, rather than expands so it's not a true escalation effect).
- A Fisherian debt-deflationary cycle in which a crisis worsens balance sheets, causes spending and asset prices to decline which worsens more balance sheets.
Debt-deflationary cycles were in full display in the 1929-32 and 2008-9 financial crisis, producing very different outcomes as policy reaction was much more astute the second time around in short-circuiting these events:
Tax cuts and sentiment
Which leads us to the Trump fiscal stimulus. There are basically three ways fiscal stimulus works:
- Direct demand effect
- Longer-term supply effect through higher CapEx
But, especially given its late cycle implementation, it also generates forces that mitigate its impact.
- Worsening public finances; higher bond yields
- Inflationary pressures, higher Fed funds
- Higher dollar, negative for earnings and
- Higher dollar, world liquidity contraction, emerging market crisis
Leaving these mitigating forces aside, we think the main impuls from the Trump tax cut was actually through that ephemeral concept called sentiment, much less actual spending, from Bloomberg:
Business sentiment was perhaps even more bullish, from Tradingeconomics:
As companies didn't actually CapEx all that much in response to the tax cuts, from CNBC (our emphasis):
Consumer spending, which accounts for more than two thirds of U.S. economic activity, grew by 4 percent in the third quarter, the strongest since the fourth quarter of 2014. The strong rise in consumer spending helped offset a 7.9 percent decline in business spending. That was the biggest quarterly decline in business spending since the first quarter of 2016.
Since by far the biggest tax cuts where for business, rather than income tax this is at least indicative of the impact being sentiment induced, rather created by than actual effects on disposable income from the tax cuts.
Driven by the positive sentiment GDP growth reached 4.2% in Q2 even if part of this came from a surge in exports which was in part trade-war related (Buying ahead of tariff implementation):
And then there is of course that ultimate sentiment index, the stock market. Most of the great Trump stock rally was based on the prospect of, and then implementation of tax cuts, more in particular corporate tax cuts.
The benefits are obvious, corporations paying less tax on their earnings mean they keep more of them, increasing net earnings significantly.
You see a 25% earnings rise in Q2 (y/y) which is quite remarkable this late in the cycle. But you already see one problem emerging, peak earnings. What's the problem, you might ask.
After all, the stock market didn't go up 25% this year so it has gotten cheaper, and earnings are still projected to rise next year, which should to set us up for a nice rally (trade war and Italy providing).
But here is where things seem to turn south, pick your reason, these are by no means mutually exclusive:
- Waning world economic growth
- Waning of tax cut impact
- Trade war escalation fears
- No-deal Brexit fears
- Italian public finance fears
- Yield curve flattening (or even inversion)
Apart from perhaps the no-deal Brexit and especially the Italian budget (which is another self-reinforcing situation which we described here), this doesn't seem to be enough for the wild sell-off we're seeing in the markets, the economy and earnings are still expected to grow healthily next year.
But there is another danger lurking from this worsening of sentiment. This could be another self-reinforcing feedback loop in the economy and basically reverse of what we've seen happening in 2018.
The most well known proponent of this mechanism is economist Roger Farmer, who argued (Project Syndicate, our emphasis):
In my work, expectations – or so-called animal spirits – are a new and independent fundamental that determines the steady-state unemployment rate. When we feel rich, we are rich. And if animal spirits are indeed fundamental, it becomes important to understand the factors that determine swings in confidence.
For the aficionado's, Farmer has set out his model in numerous articles (and even a book last year which was reviewed by SA contributor Brian Romanchuk here on SA), the most accessible of these is the one from Voxeu (our emphasis):
New Keynesian macroeconomic policy is based on the assumption that prices and wages are ‘sticky’. We assume instead that expectations are ‘sticky’ as a way to explain the real effect of monetary shocks. Following Farmer (1999, 2013), we model this idea by introducing a 'belief function' as a new fundamental... In our model people form beliefs about the future value of their stock portfolio. We assume that this belief is sustained and self-fulfilling and we identify it with what Keynes called ‘animal spirits’. A permanent shock that raises animal spirits lowers the unemployment rate forever.
We won't bother you with the technicalities of the model, but in our view there are some advantages:
- It incorporates finance and asset prices in macroeconomics, this has been one of the blind spots and the main reason that the financial crisis came as a bit of a surprise for macroeconomic models. (There were of course macro-economists who predicted the financial crisis like Nouriel Roubini).
- It allows for multiple equilibria (determined by 'animal spirits') and self-reinforcing feedback loops.
- Expectations are endogenous.
- It opens up another tool for monetary policy (see below).
It is important to note that the above causation also works the other way around, or "if we feel poor, we are poor." that is, if stock price falls become big enough they tend to produce a self-fulfilling prophesy by depressing real production and employment.
While such self-fulfilling prophesy is clearly a problem, the solution (or at least a policy instrument which can counter the situation) suggests itself.
If sentiment depends on stock prices, central banks should stabilize stock prices, is a pretty logical conclusion. According to some, the Fed is raising rates because it thinks it can't lower them enough from present levels to counter the next recession.
Worry no more, it doesn't have to, when the next recession hits (or perhaps even better, before that actually happens), it should simply buy stocks. It can sell these stocks in times of euphoria, which can prevent bubbles to form.
If sentiment depends on asset prices and if it can feed on itself, producing real outcomes influencing output and employment, then there is a case to be made for the central bank to intervene.
This isn't different in kind to what it already does with asset prices, it's 'leaning against the wind' just the same, only with other activa.
We are not entirely convinced, but it's an interesting idea nevertheless. We think there is a clear case that asset prices can create positive feedback loops through sentiment, we think we've just witnessed this in the run up to the Trump tax cuts.
Asset prices, and hence sentiment, started to improve well in advance, and on first evidence the tax cuts, which were mainly corporate tax cuts did not create much additional spending.
It's also possible that the present rapid deterioration in the markets fouls sentiment to such an extent that it becomes a self-fulfilling prophesy, taking down growth and employment with it.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.