“Monetary and fiscal policy will be helpless in stopping any oncoming economic tsunami.”
Michael Roberts is an Economist in the City of London and prolific blogger
Cross-posted from Michael Roberts Blog
The debt owed by corporations in the major economies has risen since the end of the Great Recession in 2009. With global growth slowing and the prospect rising of an outright global recession recurring ten years after the last one, the debt held by corporations may soon become so burdensome to a sufficiently large number of companies that it triggers a round of corporate bankruptcies. The banks will then see a sharp rise in non-performing loans. That could lead to a new credit crunch as banks refuse to lend to each other.
Such a credit squeeze briefly erupted last month, when the US Federal Reserve was forced to inject over $50bn into the banking system in order to reverse a very sharp rise in inter-bank interest rates as cash-flush banks refused to help out weaker ones. The cause of that squeeze was a rise in the supply of government bonds as the Trump administration issued more to cover its rising budget deficit. Some banks were not able to fund the purchases they were committed to without borrowing. So, as bank reserves held with central banks in US, Europe and Japan have surged, interbank money market volume has declined.
As a result of this shock to the credit markets, the Fed has returned to the market to buy short-term Treasury bills to restore bank liquidity. So, having ended quantitative easing (buying bonds) and started to hike its policy interest rate last year, the Fed has had to backtrack, cut rates and re-introduce QE again. More than half of central banks are now in easing mode, the biggest proportion since the aftermath of the financial crisis. During the third quarter of 2019, 58% of central banks cut interest rates.
In its latest Global Financial Stability report, the IMF expressed its worry that: “corporations in eight major economies are taking on more debt, and their ability to service it is weakening. We look at the potential impact of a material economic slowdown—one that is as half as severe as the global financial crisis of 2007-08 and our conclusion is sobering: debt owed by firms unable to cover interest expenses with earnings, which we call corporate debt-at-risk, could rise to $19 trillion. That is almost 40 percent of total corporate debt in the economies we studied, which include the United States, China, and some European economies.”
And in emerging markets: “external debt is rising among emerging and frontier economies as they attract capital flows from advanced economies, where interest rates are lower. Median external debt has risen to 160 percent of exports from 100 percent in 2008 among emerging market economies. A sharp tightening in financial conditions and higher borrowing costs would make it harder for them to service their debts.” Tobias Adrian and Fabio Natalucci, two senior IMF officials responsible for the Global Financial Stability Report, said: “A sharp, sudden tightening in financial conditions could unmask these vulnerabilities and put pressures on asset price valuations.”
I have suggested for some time (years) that corporate debt could be the financial trigger for a new recession. It was housing debt (sub-prime mortgages) in 2007-8; now it could be corporate debt (through ‘leveraged loans’ ie loans companies already loaded with debt).
Now it seems that the IMF is catching on to that possibility. Ex-Goldman Sachs chief economist and now columnist for the FT, Gavyn Davies, has also latched on to this growing risk. Davies commented: “I argued in March that this problem was not yet dangerous, but that was probably too complacent.” He was complacent, he says, because “Although US corporate debt-to-income ratios were already close to all-time peaks, other aspects of company balance sheets and financial flows were in much better shape. Profit margins were still fairly robust, the net financial balance of the corporate sector was in comfortable surplus, interest-to-income ratios were low and debt-to-equity ratios were healthy.” But now: “In the last six months, the condition of US corporate finances has become more worrying. As in other major economies, profit margins have come under increasing downward pressure, because producers’ wage costs have been rising more rapidly than selling prices to the consumer.”
As a result of shrinking proﬁt margins and slowing revenue growth, earnings for S&P 500 companies are now estimated to have fallen in the past 12 months, down from 20 per cent growth in 2018. Furthermore, earnings growth for the large quoted companies contained in the S&P 500, including foreign proﬁts, has been much higher than the ﬁgure for the entire company sector in the domestic economy. Those ﬁgures show that US proﬁts have risen by only 6 per cent in the last three years, compared with an increase of 50 per cent for the S&P 500. And non-financial sector profits are actually lower than in 2014! It’s a profits recession.
In a previous post ahead of Davies, I looked at the earnings results of the top 500 companies by stock market value in the US, S&P-500. With nearly all results in for the second quarter of 2019 ending in June, total earnings (profits) are up only 0.5% and sales revenues up only 4.7%. After taking into account current inflation, real earnings were negative and revenues barely positive. And that’s for the top 500 companies. For the smaller companies, the situation is even worse. Earnings are down over 10% from last year and revenues up only 2.2%, or flat after inflation. Excluding the finance sector, earnings would be down 21%. A sector analysis shows that the retail sector did best as the American consumer went on spending, along with the finance sector. But productive sectors like technology saw a 6.3% fall in profits. And that is key. For the first half of 2019, the earnings are in negative territory compared to a 23% rise in the first half of 2018. And the forecast for Q3 earnings is for a further fall of 4.3% yoy.
Davies reckons that: “The deterioration in profits growth has been accompanied by more aggressive corporate financial behaviour, while real capital investment to expand productive capacity has been cut back. According to the IMF stability report, share buybacks, dividends and merger and acquisition activities — financed by leveraged loans and high-yield bonds — have surged in 2019. These activities have spread to small and medium-sized firms, which the IMF says are particularly vulnerable on the profit front.” Exactly. As profitability (and now even the mass of profits) falls, companies have tried to counteract this with financial speculation. That might be okay for large firms with considerable cash reserves but not for smaller companies that are not cash-rich.
So Davies now concludes exactly what I argued some time ago. “Taken in isolation from other economic shocks, such corporate financial weaknesses are unlikely to trigger a recession, but they could certainly exacerbate the effects of other contractionary shocks. This is what happened in 2008, when a medium-sized shock in the subprime mortgage market caused an enormous downturn in economic activity. The impact of the trade disputes on business confidence, which has been collapsing in recent months, is the most obvious current threat.”
At the same time as Davies reached this conclusion, the chief US economist for the Societe Generale bank, Stephen Gallagher, argued that US recessions are typically preceded by an erosion in corporate profit margins, or profit per dollar of revenue. Costs generally rise near the end of the cycle while sales flatten out. There is a profit cycle – something that readers of this blog will know well. The current profit margin cycle (the blue line in the graph below) is reaching the point of a recession. The graph shows the historic trend in profit margins at various stages of the business cycle, as well as the margins in this cycle.
Gallagher points out that US profit margins have been squeezed since 2016. “The erosion in margins is the key to business-cycle dynamics,” says Gallagher. “If the U.S. does enter a recession in 2020, history is very likely to view it as a trade-war recession. But trade tensions are only the catalyst, not the main cause.” he says. “With a backdrop of weak profit expectations, the trade uncertainty poses serious challenges for business planning,” Gallagher argues. “In an environment of much stronger profit margins, the same trade uncertainty would likely pose less of a deterrent.”
As economic historian and author of Crashed, Adam Tooze tweeted, “What if we orientate our analysis of business cycle around what is presumably the basic driver of business activity i.e. corporate profits, rather than intermediate factors that may or may not seriously impact those profits e.g. tariffs?” Exactly. A financial crash or a trade war does not lead to an economic recession unless there are already serious problems with profitability.
It is not just Gavyn Davies and the IMF that are waking up to the financial and debt risk. In a speech on 25 September, Fed governor Lael Brainard said that “financial risk-taking by US companies in the form of payouts and M&A has increased — in contrast with subdued capital expenditures. Surges in ﬁnancial risk-taking usually precede economic downturns. As business losses accumulate, and delinquencies and defaults rise, banks are less willing or able to lend. This dynamic feeds on itself.” So the Fed must act with new monetary easing: “The Fed will decide whether to activate its countercyclical capital buffer in November. This mechanism enables the Fed to require the nation’s largest banks to increase capital buffers against the time when economic stresses emerge.”
Over in Japan, it is the same story. The Bank of Japan’s chief Kuroda called for a mix of steps to boost economic growth. He returned to what used to be called the three arrows of Abenomics: monetary easing, flexible fiscal spending and structural reforms to raise the country’s long-term growth potential. Kuroda is still convinced that central banks can save the day, even if governments should also help with fiscal stimulus measures. “We are equipped with unconventional tool kits, so there is no need to be too pessimistic about the effectiveness of monetary policy.” Kuroda hinted at further easing as early as this month.
But as I have discussed in detail before, monetary policy easing has failed to restore pre-2007 growth rates and is now unable to stop the oncoming recession. Indeed, interest rates globally are at record lows and even negative in many major economies, and yet the world economy is still slowing to a stop.
At the recent IMF-World Bank meeting, former governor of the Bank of England during the Great Recession, Mervyn King reckoned that the “world economy is sleepwalking into a new financial crisis because mainstream economics and official institutions have still not changed their complacent and faulty ideas before the last crash. By sticking to the new orthodoxy of monetary policy and pretending that we have made the banking system safe, we are sleepwalking towards that crisis.” King went on: “resistance to new thinking meant a repeat of the chaos of the 2008-09 period was looming.” This was rich of King, who before 2007 has remarked at how well the world economy was doing – ‘a nice decade’ he called it. He too was stuck in the ‘old thinking’ then.
Echoing my own view of what I call The Long Depression, King said the world economy was stuck in a ‘low growth trap’ and that the recovery from the slump of 2008-09 was weaker than that after the Great Depression. “Following the Great Inflation, the Great Stability and the Great Recession, we have entered the Great Stagnation.” King supported the view regularly expressed by Keynesian former US Treasury secretary Larry Summers of the concept of secular stagnation, a permanent period of low growth in which ultra-low interest rates are ineffective.
If monetary policy is now useless despite the vain hopes of Powell at the Fed or Kuroda at the BoJ, what is to be done? King claims the problem was “a distorted pattern of demand and output” ie excessive investment in China and Germany and insufficient investment elsewhere. There has to be a global shift in savings and investment. But apart from the obvious question of how such a shift could possibly be achieved without international cooperation, it is not a ‘global imbalance’ that is the problem. There has been such an imbalance for decades. The US, UK etc have regularly run current account deficits while Germany, Japan and China have run surpluses. And yet economic growth has still taken place. The cause of regular and recurring crises can be found in the arguments of Gavyn Davies, not Mervyn King.
Everywhere, whether among mainstream economists or official institutions, the cry now is for ‘fiscal stimulus’. For example, Laurence Boone and Marco Buti, OECD economists call for Right here, right now: The quest for a more balanced policy mix. “while monetary policy is widely recognised as facing increasing constraints, fiscal policy and structural reforms need to play a stronger role. In particular, fiscal policy could become more supportive, notably in the euro area. Undertaking the right type of public investment now – in infrastructure, education or to mitigate climate change – would both stimulate our economies and contribute to making them stronger and more sustainable.”
Just as Keynes claimed it would be necessary in the 1930s Great Depression, now, as the Long Depression enters its tenth year, the answer is for higher government spending, tax cuts and budget deficits (and don’t worry about rising government debt any longer). But just as fiscal stimulus did not work in the 1930s (instead it took a world war and governments taking control of savings and investment), so it will not work this time either. And that is assuming that politicians will even try it.
Fiscal stimulus and government ‘management of the economy’ is the touchstone of Keynesian and post-Keynesian thinking, including so-called Modern Monetary Theory (MMT). The only real difference between Keynesian and MMT stimulus is the latter think it can be done without issuing bonds to fund it: ‘printing money’ is just fine.
The real shock is that even some Marxists consider that fiscal stimulus and more government spending is all we need to avoid a new slump. The question of falling profitability and profits highlighted by Gavyn Davies is apparently not relevant at all. The profitability of capital apparently plays no key role in this profit-making capitalist system. You see profits come from investment, not vice versa. So all we have to do is boost investment.
Take a recent article by John Weeks, a longstanding leftist (Marxist?) economist who once wrote a brilliant paper back in the 1980s (John Weeks on underconsumption) that showed Marxist crisis theory had nothing to do with a lack of effective demand caused by the underconsumption of workers. Weeks is now the coordinator of the Progressive Economy Forum, a leftist think-tank. He now writes: “Market economies require policy management: (as) Keynes taught us.” You see back in the Golden Age of the 1960s when economic policy-makers followed Keynes and intervened with fiscal measures to manage the economy, there was high economic growth and no crises. It was only when Keynesian management was dropped by neo-liberal governments that crises ensued.
Weeks now argues that “capitalist economies do suffer periodically from extreme instability, the most recent example being the Great Financial Crisis of the late 2000s. These moments of extreme instability, recessions and depressions, result … from private demand “failures”; specifically, the volatility of private investment and to a lesser extent of export demand.” Weeks correctly points out that it is the volatility in investment that causes booms and slumps, not private consumption. But what causes the swings in investment? Weeks offers a straight Keynesian answer: “The instability results because investments are made in anticipation of future economic conditions, which are uncertain.” So it is uncertainty about the future – a subjective cause and nothing to do with the objective picture of the current profitability of investment.
If Weeks (and the Keynesians) are right, then indeed, “public expenditure (can) serves to compensate for the inherent instability of private demand. This is the essence of “counter-cyclical” fiscal policy, that the central government increases its spending when private demand declines, and raises taxes when private expenditures create excessive inflationary pressures. During 1950-1970 that was the policy consensus, and it coincided with the “golden age of capitalism“.
But it is not right. First, the golden age did not come to an end because Keynesian policies were dropped; on the contrary, Keynesian policies were dropped because the Golden Age came to an end. And that was because the profitability of capital took a serious dive from the late 1960s to the early 1980s in all the major capitalist economies. As a result, investment was volatile and economies suffered several slumps. Far from Keynesian demand management stopping these swings, even in the 1950s and 1960s, they actually exacerbated them. At least that was the view of the leading British Keynesian economist of the 1960s, Christopher Dow, who summed up his monumental history of the period: “The major fluctuations in the rate of growth of demand and output in the years after 1952 were thus chiefly due to government policy. This was not the intended effect; in each phase, it must be supposed, policy went further than intended, as in turn did the correction of those effects. As far as internal conditions are concerned then, budgetary and monetary policy failed to be stabilising, and must on the contrary be regarded as having been positively destabilising.” (JCR Dow, The Management of the British Economy, 1964)
Second, investment does not lead profits, but vice versa in a capitalist economy. It is not the lack of private demand that causes a crisis; but a crisis is just that: a lack of effective demand. But this ‘realisation’ crisis, to use Marx’s term, is the result of the profitability crisis. That is where any proper analysis should start on the causes of crises – as now Davies and Tooze suggest. I and others have presented both theoretical (Marxist) and empirical support for this causal connection. Keynesians may deny it, but it seems that even mainstream economists like Gavyn Davies have now woken up to this causal connection. If this is right, then attempts to avoid a new slump using fiscal policies will not curb or reverse the fall in corporate profits and investment – and thus will not avoid a new slump.
There is already a global manufacturing recession. The German economy as a whole is in virtual recession, according to its own central bank, the Bundesbank. China is now growing at its slowest pace in nearly 30 years. The trigger points for a global slump are multiplying. We have riots and protests against austerity cuts in several ‘emerging economies’ as the global slowdown hits exports and revenues: in Lebanon, in Ecuador, in Chile, in impoverished Haiti. At the same time, the larger emerging economies are either in a slump (Argentina, Turkey) or in stagnation (Brazil, Mexico, South Africa).
Even in the US, the best performing major advanced capitalist economy, growth is slowing, while investment and profits are falling. And within that, one of America’s major companies is in deep trouble. The grounding of the 737 Max jet after two tragic crashes has quietly lowered US growth, reduced productivity and trimmed earnings at a number of American companies. Boeing is no ordinary company. It is the largest manufacturing exporter in the US and a very large private employer. Its products cost hundreds of millions of dollars and require thousands of suppliers. It is no surprise that benching Boeing’s fastest-selling aircraft is having ripple effects throughout the economy. Economists put the drag on growth from Boeing at around 0.25 percentage points in the second quarter while the White House Council of Economic Advisers reckoned the damage was even greater: Boeing’s troubles cut GDP from March through June by 0.4 percentage points.
Monetary and fiscal policy will be helpless in stopping any oncoming economic tsunami.