One week ago, Deutsche Bank’s Dominic Konstam unveiled, whether he likes it or not, what the next all too likely step will be as central bankers scramble to preserve order in a world in which monetary policy has all but lost effectiveness: “It is becoming increasingly clear to us that the level of yields at which credit expansion in Europe and Japan will pick up in earnest is probably negative, and substantially so. Therefore, the ECB and BoJ should move more strongly toward penalizing savings via negative retail deposit rates or perhaps wealth taxes.”
Many were not happy, although in reality the only reason why the DB strategist proposed this disturbing idea is because this is precisely what the central banks will end up doing.
Today, he follows up with an explanation just why the central bankers will engage in such lunatic measures: quite simply, he thinks that economic contraction is now practically assured – and may have already begun – for a simple reason: contrary to popular belief, this particular “expansion” will die of old age after all, and won’t even need the Fed’s intervention to unleash the next recession (if not depression).
There is an old saying amongst market watchers that economic expansions do not die of old age. Rather, during the course of the business cycle dynamics emerge that threaten to become unacceptable from a policy perspective. In the context of economic expansion, that dynamic has been inflation. The conventional pattern has been that as expansions mature, demand for labor outstrips the available supply, creating upward pressure on wages. In the presence of pricing power, higher wages are passed along to end consumers through higher prices. Profits decline to the extent that wage acceleration outstrips price increases. The point is that the historical template has the Fed, as an exogenous agent, raising rates to slow wage growth and inflation and to restore profits. In this sense the cycle is actively terminated, rather than “dying of old age”.
A number of stylized facts about the business cycle are apparent historically. Recessions always occur as part of an effort to restore profit growth. Profits are almost always dependent on productivity growth. Productivity recoveries almost always involve reduced labor demand. Productivity recoveries usually follow a period of stronger wage growth – and in that way productivity and wages are correlated. It is the strength in wages, however, that pressures profits unless passed through into higher prices. It is therefore always the case that recessions involve a period of central bank monetary tightening aimed at curbing any pass through of higher wages into prices and thus forcing a slowdown in labor demand to boost productivity via a recession and to then curb the rise in wages. Recessions are effectively created by policymakers to counter otherwise accelerating inflation.
However, this time it’s different. As Konstam writes, “the current cycle is distinct in that pricing power is generally lower than in the past… This is likely because of the now well worn theme of global competition: production can be moved to lower wage centers, allowing constant or larger profits in an environment of steady or even lower prices. Lower pricing power reduces the ability of the corporate sector to pass along even mild wage increases to consumers and makes profits that much more vulnerable.“
Then there is the issue of plummeting productivity, something discussed here extensively in the past:
A second unique aspect of the current cycle is that productivity growth across major economies has been stubbornly low throughout the cycle. We have particular sympathy for the idea that demographic changes are at least in part responsible. The aging of the baby boomer generation has been reflected in an aging workforce, and productivity growth in older workers is lower than in younger workers for life cycle reasons: these workers are further removed from education or vocational training in the use of technology and at any rate have already acquired a set of job related skills.
Because in equilibrium workers are paid their productivity, stagnant productivity growth implies static wage growth. It is incorrect, however, to presume that faster wages imply concurrent faster productivity growth. Higher productivity might have followed higher wages in the past, but only by virtue of reduced labor input that was meant to contain wage growth relative to consumer prices and restore profits.
If imbalances arise in the supply of and demand for labor, wages might temporarily accelerate more rapidly than underlying trend productivity growth. This creates a profits problem. The Fed restores productivity by slowing aggregate demand, allowing labor input to decline more rapidly than output. Higher productivity restores profits: wage increases are “paid for” by increasing output per unit labor input. As with lower pricing power, stubbornly low productivity growth makes (falling) profits weaker on the margin.
Konstam then flips the entire “old age” question on its head and asks the relevant question namely whether the Fed is still needed to create a recession given the characteristics of the current economic cycle.
We would argue that it is not. Last week’s employment report illustrates that there is still very little or no wage pressure. This points to the persistent presence of slack in labor markets, perhaps because NAIRU is lower than even the latest estimates. Moreover, to the extent that the Fed is seeking to increase wage share, they should be biased to remain “behind the curve” pursuant to optimal control. Note that the absence of wage and price pressure and a static Fed are more or less consistent with the current level of yields and the shape of the curve, while optimal control would bias the curve steeper in a bearish fashion.
So if Fed action (read tightening) is not needed to induce a recession, what could be the catalyst? According to DB, two things.
The first is a demand shock. This could in principle occur as a result of Fed tightening as during the 2007/2008 housing shock which occurred well after the Fed effort to curb wage growth was under way. In these instances the demand shock forces rapid reductions in labor demand due to the profit drain from higher wages. The central bank usually reverses course quickly with monetary easing, and fiscal stimulus is deployed to counteract the negative demand shock. In terms of market movement, the reaction of policy makers to a demand shock would bias the curve to steepen bullishly.
In the current environment, savings rates are rising and likely to continue to do so. We have recently argued that demographics are pushing the labor force participation rate lower, which exerts upward pressure on the savings rate. It is not clear the consumer has experienced a shock sufficient to create a recession. However, to a larger extent a slow rise in savings is to be expected given the demographic picture – a large proportion of baby boomers are approaching retirement, when savings rates are typically highest – and because twenty-somethings need to save for homeownership for longer than previously given more stringent credit standards. A shock rise in savings would require a collapse in risk assets including house prices. Such a shock could emanate from a disorderly deleveraging in China, perhaps accompanied by a lumpy devaluation. We would argue that – thanks to the unfolding relent – scenarios such as these are less likely now.
Maybe, although as we showed recently, as of March, the US savings rate following numerous revisions, was already at the highest in over three years and rising.
Which brings us to Konstam’s worst case scenario, one which is quickly starting to smell like the credit analyst’s “base-case” namely the “third avenue for recession” which Deutsche Bank believes is the worst of the three. “This is an endogenous slowdown in labor demand that results because corporations are not just tired of negative profit growth, but also because they are drawing a line in the sand from the perspective of defending margins. No one knows where that line is. But payroll reports like last week’s suggest it could be around here. We have had the worst profit recession since 1971 but profit share is still in the low 20 percent range, having peaked around 24 pct. The worst level has been in the mid to low teens.”
And the punchline:
An endogenous recession – not due to a negative demand shock or Fed policy tightening – is the worst because not only does it speak to policy impotence, but it also highlights the inherent contradiction in capitalism that has worried economists for over a century. That contradiction is that profits, savings or “surplus” must be continually plowed back into the economy to support growth, yet doing so runs the risk of undermining the next profit cycle through over supply. If profits are not plowed back, corporations run the risk of deficit demand. In simple terms, a line in the sand for profit share means that corporations end up firing workers who just happen to be consumers as well.
But why plow back profits into the economy when one can just buy back stock instead and make owners of capital wealthy beyond their wildest dreams when you have every central bank, and in the case of the ECB explicitly, backstopping bond purchases so that the use of proceeds can just to to fund buybacks.
Or, god forbid that the “inherent contradiction” not in capitalism but in the neo-Keynesian model is revealed, exposing all those tenured economists and central bankers as clueless cranks, and finally vaulting Austrian economics to the pinnacle of economic thought.
The irony, of course, is that once the global economy falls into the deepest economic depression the world has seen – perhaps ever – everyone will be shocked and confused hot it is that we go there when “markets” kept rising, and rising, and rising…
Sarcasm aside, let’s summarize: according to Deutsche Bank the worst kind of a recession, an “endogenous one” in which labor demand plunges as “corporations are not just tired of negative profit growth, but also because they are drawing a line in the sand from the perspective of defending margins” may be imminent… or is already here because based on “payroll reports like last week’s suggest it could be around here.“
Surely, that alone should be enough to send the S&P to new all time highs.
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And for those wondering: yes, according to DB things will get worse simply because they have to get worse to offer some hope for an actual mean reversion-based recovery. Sadly, as DB is all too correct, the only way that central banks have ahead of them now involves more negative rates, more wealth transfers, and of course, the infamous “wealth tax” DB touched upon last week.
Things will need to get worse before policy can become radically better. That may involve piling more debt from government onto existing debt, coupled with “helicopter money” elements to reduce some of the burden for existing debtors. It could involve a direct transfer away from profits and savers to workers and spenders via negative rates and wealth taxes that banks collect either way. There is light at the end of the tunnel. But we have yet got to the right tunnel and probably won’t until the US falls into a recession.
Actually, make that a depression, because when central banks have really nothing left to lose, that’s when the terminal step in fiat debasement can finally begin.
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