The Business Cycle: Simplified
Most everyone understands the business cycle; 7-10 year periods of economic expansion followed by recessionary contraction in GDP. A technical recession is two consecutive quarters of declining GDP, characterized typically by tightening credit and a flight from risk assets. Recessions are those ‘features’ within economic law which allow for the repricing of risk assets relative to historic norms and the opportunity for overly levered firms/households to ‘re-adjust’.
There can be no doubt that recessions are testing, and cause real pain to both households and corporations. left to their own devices, households and firms will increasingly take on leverage as the business cycle ages. We know that during the early years of an expansion debt is effectively used to increase productivity. Meaning that the increases in output/productivity pay for the cost of the debt (service and principle), which is good!
As the expansion ages, the incremental borrowing becomes less effective at producing productivity growth. With a focus on the rear view mirror, households and firms begin spending their borrowed dollars more on consumption and less on productivity growth. Individuals borrow money to purchase risk assets at high valuations. Everyone thinks there is no end to the prosperity.
Behind the scenes, Debt Service to Income ratios deteriorate and increasingly additional debt is used to service preexisting debt. Central banks typically catch on to the situation late and begin by tightening monetary policy through interest rate increases. The cost to service debt increases at a time when incomes are already growing slower relative to debt growth. The path is unsustainable.
Eventually there is a turning point where sentiment changes. What were once self-reinforcing factors become self-defeating. The tightening in monetary policy makes credit more expensive as borrowers begin to feel the squeeze. Lenders become more reluctant to extend credit, which in turn squeezes borrowers more.
Eventually certain overly extended sections in the economy show signs of weakness as the firms/households which constitute said sectors cannot meet their debt service payments. They sell assets in an attempt to produce cash, which leads to price depreciation in risk assets (Stocks and High Yield Bonds). As assets lose value there is a Negative Wealth Effect; borrowers become less creditworthy as their collateral values fall. People feel less rich as their net worth’s decline. The cycle feeds on itself as credit contracts and borrowers get squeezed even more.
Firms/Households default on their debts which leads to deflationary pressures that contribute to economic contraction.
They Always Print:
Sooner or later the central bank loosens monetary policy by dropping interest rates (usually by ~5%). The decline in rates can cause temporary rallies in risk assets (bear market rallies), but usually the decline is not over yet.
The central bank tries to match the deflationary pressures of debt defaults and restructurings with inflationary stimulus through interest rates at first, and then unconventional easing later. If interest rates hit 0% and cannot be lowered any further, other forms of stimulus are required to fight deflationary pressures: Quantitative Easing. CB’s purchase financial assets in an attempt to push money into the system. Often this can crease “synthetically negative interest rates”.
If the deflationary pressures are matched and the CB has the authority and expertise, the deleveraging become less painful and economic contraction begins to bottom. Recessions end with risk assets oversold and borrowers re-positioned to healthier debt ratios.
Is Pain Unavoidable?
History tells us that households and firms will leverage themselves beyond what is reasonable and eventually pay the price. Psychology certainly plays a large roll because human tendency is to weigh recent history more when ‘predicting’ future outcomes.
Stock markets correct and overly indebted firms default. Pain is felt when wealth gets destroyed.
Where are we now?
The United States is currently running at its lowest unemployment in almost 50 years and were set to break the record for the longest US expansion by this summer. So this is likely the BEST the US will get for this cycle, yet last year the fiscal deficit was 3.8% of GDP and the latest has put 2019 at 5.1%.
The Fed has paused hiking at 2.5% and has announced the end of its balance sheet runoff in September (no more autopilot here).
When the next recession hits, fiscal deficits will run through the roof and you can bet that the Fed will be printing at full speed. At 2.5%, cutting to 0% doesn’t do much so Powell is going to end up with another couple rounds of QE, and i’ll be damned if the political Left doesn’t put up one hell of a fight for that money.
The Result >>> Pushing on a String (which is a topic for another day)
My biggest fear is a period of massive stimulus packages that do nothing for growth and productivity, a declining confidence in the CB as we enter a lost decade.. those fears are probably overdone, but who knows.
Thanks for reading.