Speaker 1: Hello, and welcome to another episode of the Odd Lots Podcast.
Speaker 1: I'm Joe Wisenthal and I'm Tracy Alloway. Tracy, obviously, we're
Speaker 1: in a moment in which there's a lot of debate
Speaker 1: about whether we're headed for an imminent recession, maybe in
Speaker 1: the next few months or maybe in the next year. Right.
Speaker 1: I think we're recording in the week that Jamie Diamond
Speaker 1: was talking about how we're definitely heading for a recession.
Speaker 1: The only question is timing, which is kind of always true,
Speaker 1: I guess, but it definitely feels like the chorus of
Speaker 1: people talking about a potential recession is getting louder. Yeah,
Speaker 1: between the trade war, the curve and version which as
Speaker 1: of right now is actually uninverted. Uh, some we data
Speaker 1: in the US. Uh, there's clearly we're back on recession watch.
Speaker 1: There's no real doubt about that. But as you point out,
Speaker 1: we're always heading for recession, and Jamie Diamond point out,
Speaker 1: it's only it's only a matter of time. At some
Speaker 1: point we'll have another one. So to say we're headed
Speaker 1: for one but we don't know why, it's kind of obvious, right,
Speaker 1: And I think we're still in the longest economic recovery
Speaker 1: on on record now, right, So we're kind of do
Speaker 1: for something to happen. But I think there's a more
Speaker 1: perhaps interesting and consequential question for investors in the economy
Speaker 1: than merely when will the recession happen? What's that? Well,
Speaker 1: I think the bigger question is when the recession hits,
Speaker 1: what's it going to look like? Because we've been scarred
Speaker 1: recently or recent recessions have all been pretty brutal in
Speaker 1: some sense. So if you think about the recession that
Speaker 1: started in two thousand seven, the financial crisis that was horrible,
Speaker 1: the recession that came after the dot com boom, it
Speaker 1: wasn't really devastating overall, and it was kind of quick,
Speaker 1: but you know, it was a tremendous loss of wealth
Speaker 1: due to the crash in the stock market. And prior
Speaker 1: to that, we had a recession, uh, following the savings
Speaker 1: and loan crisis. So we don't have we don't seem
Speaker 1: to have these sort of old style recessions anymore. They
Speaker 1: always seem to be accompanied by something big in systemic Well,
Speaker 1: people who talk about recession now do seem sort of
Speaker 1: oddly hopeful that the next one is going to be
Speaker 1: what they call a shallow recession. Right. You hear people
Speaker 1: who talk about it every once in a while and say,
Speaker 1: just because it's a recession, that doesn't mean it's going
Speaker 1: to be like two thousand eight all over again. We
Speaker 1: can have a contraction in economic growth without a huge
Speaker 1: crisis in the financial sector. But I think what you're
Speaker 1: getting at is whether or not that's true, and whether
Speaker 1: the examples of recession slash financial crises that we've seen
Speaker 1: over the nearest past decades suggests that that maybe that
Speaker 1: can't happen anymore. Yeah, this really is the big question.
Speaker 1: Like we don't want to be too um, I guess
Speaker 1: scarred by recent events to say, oh, every recession now
Speaker 1: is going to be a crisis. But on the other hand,
Speaker 1: we don't want to dismiss the fact that, uh, the
Speaker 1: sort of old business cycles is we know them have
Speaker 1: given way to financial market cycles, and that sort of
Speaker 1: is seemed to seeming to be the main driver, and
Speaker 1: in fact, you know, there's not novel concept. Jerome Powell
Speaker 1: at Jackson Hole two summers ago kind of said the
Speaker 1: same thing that whereas the FED on our traditional models
Speaker 1: think about trade offs of inflation and jobs and the
Speaker 1: sort of very sort of standard view of the economy
Speaker 1: overheating and then slowing down. The real game in town
Speaker 1: is what happens with asset prices and how it declined.
Speaker 1: An asset prices uh spills over into real economic activity. Right,
Speaker 1: So if you think that the economy has become financialized,
Speaker 1: which a lot of people do seem to think nowadays,
Speaker 1: then it would stand to reason that when we get recessions,
Speaker 1: they're going to be financialized as well. I like this topic, joke.
Speaker 1: I like this topic too, and we have the perfect
Speaker 1: guest for it today. Today we're going to be speaking
Speaker 1: with David Levy. He is the chairman of the Jerome
Speaker 1: Levy Forecasting Center, and you recently came out with a
Speaker 1: very interesting report called Bubble or Nothing, and it talks
Speaker 1: about how the private sector swelling balance sheets compel increasingly
Speaker 1: risky financial behavior and it really addresses the role, the
Speaker 1: growing role that financial assets themselves play in the economy
Speaker 1: and in economic cycle. And so maybe in this conversation
Speaker 1: we'll get an answer to can we have old fashioned
Speaker 1: recessions or we doomed to have big crises or many
Speaker 1: crises that are a result in swings and prices. So
Speaker 1: without further Ado, I want to bring in David Leaving.
Speaker 1: Thank you Joe, and Hi Tracy, and thanks for both
Speaker 1: of you for having me here. These podcasts are just
Speaker 1: such a refreshing change from the SoundBite world. We spend
Speaker 1: too much time and I'm really excited to think this
Speaker 1: is a great topic. Hand you on TV a couple
Speaker 1: of weeks ago and we talked for like six minutes,
Speaker 1: but it's so deep. I was like, we gotta have
Speaker 1: them back and actually do something really deep because it's
Speaker 1: such an important topic. But just to start off, would
Speaker 1: you say that our sort of characterization of the evolving
Speaker 1: nature of recessions is correct. Whereas in the old days
Speaker 1: you think about the economy overheating, maybe factories built too
Speaker 1: many widgets, there wasn't demand for widgets, the factory had
Speaker 1: to lay off some workers for a few quarters. They
Speaker 1: draw down the inventory of widgets than they build up
Speaker 1: them up and everything is back again. That just doesn't
Speaker 1: seem to be the way cycles work. I agree very
Speaker 1: much with with with the thrust. What you're saying, I'm
Speaker 1: going to try to paraphrase a little bit by saying
Speaker 1: what has changed is that as private sector balance sheets
Speaker 1: have become larger and larger relative to GDP, relative to
Speaker 1: personal income and in which sector are we're looking at. Uh,
Speaker 1: they have increasingly dominated the cycle. So things like balance
Speaker 1: sheet effects such as wealth effects when the stock marker
Speaker 1: goes up or down a lot, major refinancing effects when
Speaker 1: there's vast amounts of debt they get refinanced at lower
Speaker 1: rates and people pull cash. These things have started to
Speaker 1: play a much bigger role. But also, you know, it's
Speaker 1: important to realize balance sheets have been involved in the economy.
Speaker 1: Their expansion is an essential part of how economies works.
Speaker 1: Economy cannot generate profits without balance sheets expanding. This gets
Speaker 1: into the flows of funds that give us profits. It's
Speaker 1: what we call the sources of profits um. And it's
Speaker 1: it's a process that is is perfectly natural and normal.
Speaker 1: The problem is balance sheets having grown faster than income
Speaker 1: for really since the end of World War two, a
Speaker 1: little bit on and off, but but pretty much, uh,
Speaker 1: most of the time. We've got to the point eventually
Speaker 1: by the eighties where these balance sheet effects were starting
Speaker 1: to be distorting, and that has become more and more extreme,
Speaker 1: and that is why we see a lot of the
Speaker 1: distorces It's why interest rates were forced down is by
Speaker 1: the supporting these top heavy financially top heavy economies. It's
Speaker 1: why rates of return were forced down. It's why, Uh,
Speaker 1: there's a massive amouss of wealth that swings of which
Speaker 1: are have huge influence on on people's behavior. And and
Speaker 1: that's really, uh, the new world where and it's not
Speaker 1: when we're gonna be in forever, but that is the
Speaker 1: one we're in now. So, David, you're saying that these
Speaker 1: big balance sheets basically mean that wealth has become more
Speaker 1: important and sort of bigger relative to income, and that
Speaker 1: means that wealth slash balance sheets have an outsized effect
Speaker 1: on the economy. But how did we actually get to
Speaker 1: that place? Why in the nineteen eighties did balance sheets
Speaker 1: start growing in this way? If we go back to
Speaker 1: the end of World War Two, we've just been through
Speaker 1: fifteen years of depression and war, and balance sheets were
Speaker 1: extremely low. There was no one had done much investing,
Speaker 1: they hadn't been really been, They hadn't wanted to in
Speaker 1: the depression, they hadn't been allowed to during the war. Uh,
Speaker 1: there was a huge pent up cash. All the debt
Speaker 1: had been pretty much paid off or going bad by then.
Speaker 1: And at the end of the war, we had this
Speaker 1: tremendous boom rebuilding, and this meant expanding balance sheets. We
Speaker 1: had asset prices that were depressed by all the fears
Speaker 1: brought about by depression and then war, and gradually people
Speaker 1: became more comfortable, so we had a normalization that went
Speaker 1: on maybe for up let's say into the seventies somewhere.
Speaker 1: There's no way to draw a precise line, but the
Speaker 1: problem is that there's a certain shore there and this
Speaker 1: this this kept going. I don't have you know, we
Speaker 1: don't try to explain exactly why it had to go.
Speaker 1: We we could have a long discussion about that, and
Speaker 1: there are a lot of reasons to believe that there
Speaker 1: were some forces behind it. But the important thing is
Speaker 1: we know what did happen. And once you get to
Speaker 1: the point where you start to uh, balances are so
Speaker 1: big that to support them, the FED is forced to
Speaker 1: lower interest rates. That it's not you know, housing uh
Speaker 1: just weakening or or or or car sales going down,
Speaker 1: but it's actually you have an asset market that's having
Speaker 1: a negative wealth effect or there are debt problems of
Speaker 1: financial crisis that comes when interest rates go too high.
Speaker 1: Those are the balances now start to take over interest rates.
Speaker 1: I want to talk a little bit about the sort
Speaker 1: of necessary FED response when asset prices go down. But
Speaker 1: before we do, I just want to back up the
Speaker 1: germ Levy Forecasting Center. You talked about how you use
Speaker 1: a sort of sources of profit, sectoral balances or balance
Speaker 1: sheet approach to under ending the economy. Can you just
Speaker 1: sort of talk a little bit more about what makes
Speaker 1: your approach to analyzing the economy distinct? Because when I
Speaker 1: read a lot of like self side research, I typically
Speaker 1: don't see a lot about sources of profits analysis. No, No,
Speaker 1: this is this is There are more people starting to
Speaker 1: pay attention to this. In fact, a piece which we
Speaker 1: give out a complimentary I don't know if I mentioned
Speaker 1: where profits come from. It's just an educational too. I
Speaker 1: know is used by a number of big investment houses.
Speaker 1: They've started to get interested in it. It was introduced
Speaker 1: to the discipline UH in the nineteen thirties by UH.
Speaker 1: To most people an obscure Polish economist who was a
Speaker 1: contemporary of Canes at at Cambridge, but it was that
Speaker 1: was Michael Koletsky. But he had a very left wing
Speaker 1: view of about a lot of things. There's nothing left
Speaker 1: wing about the profits identity. Profits identity of profits equation
Speaker 1: is just a cousin of the very well known savor
Speaker 1: investment identity. You just rearrange the terms because business saving
Speaker 1: is profits after taxes and dividend, so you can turn
Speaker 1: it into a profits equation and that is a much
Speaker 1: better causal way to understand what happens in the econic
Speaker 1: when investment takes place and people decide not to save
Speaker 1: too much. A lot of that the wealth created investment
Speaker 1: that isn't saved by households or governments ends up necessarily
Speaker 1: flowing to business and it becomes profits. So this way
Speaker 1: of thinking, it naturally ties into finance. You don't look
Speaker 1: at real concept. You're looking at financial flows because of
Speaker 1: the importance of investment or saving flows. It ties into
Speaker 1: balancing changes in a very direct way. Just to say,
Speaker 1: how does this different? There are people who are told
Speaker 1: you mentioned sectoral um analysis, where people there's a there's
Speaker 1: a strong tendency among a lot of people to say
Speaker 1: to look at the private sector as a whole, look
Speaker 1: at what is the net balance the private sector. I
Speaker 1: believe it is absolutely essential to separate the corporate sector
Speaker 1: from households because if if household saving goes down, that's
Speaker 1: good for profits, Yet the total may not change. The
Speaker 1: households save and profits go down the total maybe you
Speaker 1: know you're missing critical asset because business is going to
Speaker 1: make the decisions about employment, about investment, and so forth
Speaker 1: when it comes to you know, you argue that basically
Speaker 1: the rising value of assets relative to income pushes down
Speaker 1: interest rates over the long run. Can you walk us
Speaker 1: through why exactly that happens? Is it because of the
Speaker 1: central bank is forced to lower rates to support an
Speaker 1: increasingly financialized economy every time there's a sign of trouble,
Speaker 1: Or is it because the actual rising value of assets
Speaker 1: somehow exerts some sort of force on interest rates itself. Um,
Speaker 1: it's it's it's really what it compels the central bank
Speaker 1: to do. You know, the general story told by probably
Speaker 1: the majority of economists for many years. I don't know
Speaker 1: if it's still people still even be interested. It was
Speaker 1: that the reason interest rates came down under the eighties
Speaker 1: and nineties was because of falling inflation expectations. The Fed
Speaker 1: succeeded in lowering people's expectations, Therefore there was less inflation
Speaker 1: interest rates didn't have to be as high. If we
Speaker 1: look at when the FED made decisions, it was they
Speaker 1: always were raising rates until the when they thought the
Speaker 1: economy was strong and there an inflation was harder they
Speaker 1: wanted to be and they all but they stopped and
Speaker 1: reversed when the economy got into trouble and increasingly that
Speaker 1: trouble was financially related. Now, but the real interesting part
Speaker 1: is what happens when you get into a recession or
Speaker 1: financial crisis. Each time the Fed had to lower rates
Speaker 1: further in order to UH stabilize financial problems. If we
Speaker 1: go back to the UH ninety nineties, when we had
Speaker 1: the underwinding of the commercial real estate bubble, we had
Speaker 1: bicoastal housing bubbles. We also had we had a lot
Speaker 1: of LBO excesses, We were still working through the problems
Speaker 1: from the savings and loan system, and we had a
Speaker 1: lot of of fall out, a lot of balance sheet
Speaker 1: problems over capacity, things that led the Fed to to
Speaker 1: cut rates and not just through the recession, but to
Speaker 1: continue to cut them for another almost another two years
Speaker 1: before the economy finally showed some life. If we go
Speaker 1: back to them going to the next cycle, when the
Speaker 1: tech bubble burst. Instead of going down to three percent
Speaker 1: with the FED funds right, the FED had to go
Speaker 1: all the way down to one percent, again, continuing to
Speaker 1: cut after the recession ended because the economy wasn't responded,
Speaker 1: because the balancie problems, and in the latest case, it
Speaker 1: was clear that they were going to have to go lower.
Speaker 1: And I say it was clear when I When I
Speaker 1: say that, I mean we went out and I did
Speaker 1: something never done before and probably will never do again.
Speaker 1: I started a small hedge fund to do nothing but
Speaker 1: play the the eventual collapse in interest rate, because you
Speaker 1: the FED would have to go to the floor. Now
Speaker 1: we are timing wasn't perfect. Fortunately we ended up doing
Speaker 1: very well. But we I don't want to make sound
Speaker 1: like I'm too clever, because we we We certainly didn't
Speaker 1: do you know time everything thinks lasted loaning, we thought.
Speaker 1: But the point is it was clear that the next
Speaker 1: time there would be even more debt, there would be
Speaker 1: even more asset value of losing it that the FED
Speaker 1: would and the consequences will require even lower rates, And
Speaker 1: the FED was going to run out of room, and
Speaker 1: therefore we had The FED had to keep rates low
Speaker 1: for a long time. So sometimes when the stock market
Speaker 1: starts to fall and suddenly the chatter picks up among
Speaker 1: various ef I see people about rate cuts, and people say, ah,
Speaker 1: there's a FED put under the market and the Federal
Speaker 1: he cares about asset prices, and kind of what you're
Speaker 1: saying is like, that's not even a conspiracy, that's not
Speaker 1: even that's just how the world has to work these
Speaker 1: days with unfortunately or fortunately, and we don't have to
Speaker 1: make any judgments per se. But that is just kind
Speaker 1: of like the required mechanical operations because the consequences of
Speaker 1: falling asset prices in a world of gigantic balance sheets
Speaker 1: more or less leaves the FED. We have to remember
Speaker 1: the FED is is in a in a politic environment.
Speaker 1: And uh, I remember my father, who was in this
Speaker 1: business before me. Uh met with William at Chesty Martin
Speaker 1: and when he was in the FED chair, and he said, look,
Speaker 1: as long as the White House and the Congress disagree
Speaker 1: about what we should do, we can do anything we want.
Speaker 1: Implication being obviously, if everybody thinks you're not doing enough,
Speaker 1: you better do something. When if we think back to
Speaker 1: earlier in this this expansion, why why were people pushing
Speaker 1: for for zero race, Why were they pushing for qui?
Speaker 1: Why were they pushing for more? Because the economy was
Speaker 1: not behavior in a satisfactory way and people were We
Speaker 1: had fiscal stimus, but it wasn't enough and people were
Speaker 1: reluctant to use more. So the pressure was on the FED,
Speaker 1: and the FED was their Their objective is helped get
Speaker 1: the economy going, so that's what they tried to do.
Speaker 1: The problem is the FED, really and I'm really sympathetic
Speaker 1: to the FED because they really face an impossible task.
Speaker 1: Although I'm not sure they always realize it, or all
Speaker 1: all members of the of the Open Market Committee always
Speaker 1: realized it. And that is that on the one hand,
Speaker 1: you know they in order to get the economy going,
Speaker 1: you need to have balance sheets expand rapidly, especially when
Speaker 1: they're already this big, and we can talk about why
Speaker 1: that is. But at the same time, in doing that,
Speaker 1: they're making the balance she's even bigger, creating more pressures
Speaker 1: that are gonna make things worse. We see this very acutely.
Speaker 1: We happened in a very rapid time in China where
Speaker 1: we saw they would constantly turn to opening the credits
Speaker 1: big it's af tremendous debt growth as the economy started
Speaker 1: to need boost here and there. Uh, and then they
Speaker 1: began to realize they were creating something that was completely unsustainable.
Speaker 1: And now they've been back and forth trying to figure
Speaker 1: out how do they stimulate the economy but not create
Speaker 1: too big a bubble, and they're they're not doing a
Speaker 1: really great job of it. So our negative yields on
Speaker 1: debts or securities are those the ultimate expression of this
Speaker 1: lower interest rate dynamic that you're describing, Because when you
Speaker 1: think about negative yielding debt, that's something where the only
Speaker 1: way you're really making money is either through you know,
Speaker 1: some sort of currency hedging or conversion, or by selling
Speaker 1: it onto someone else, in which case it's capital gains
Speaker 1: and not income. So is that basically what the world
Speaker 1: is going to look like if if we keep going
Speaker 1: down this road. Let's start to first talking about the
Speaker 1: negative policy rates, because that that has huge impact. That
Speaker 1: is critical to having negative yields on bonds. If you
Speaker 1: are going to lower interest rates and negative rates, now
Speaker 1: you create a situation where depositors ultimately can be either
Speaker 1: paying fees on their checking accounts or they're can be
Speaker 1: paying negative interests themselves. Uh, And certainly for large depositors,
Speaker 1: this becomes a big issue. So at some point they say,
Speaker 1: all right, uh, or even if we're not being charged
Speaker 1: a feast, now, if these negative rates become more negative,
Speaker 1: we will be. So let's lock in a negative rate.
Speaker 1: So at least we won't we know how much we're losing.
Speaker 1: We won't lose as much as we might lose if
Speaker 1: something else happens. So the expectation of negative short term
Speaker 1: interest rates is critical to having negative views and bonds.
Speaker 1: If you look at the Great Suppression US, we had
Speaker 1: deflation everything else. Yields did not go negative. The couple
Speaker 1: of tining caveats in that which were special circumstances did
Speaker 1: not go negative. Un bonds because people wouldn't take less
Speaker 1: than zero. They've just hold cash otherwise. So the title
Speaker 1: of your of this paper and you talk about is
Speaker 1: bubble or Nothing. The paper details how private sector swelling
Speaker 1: balance sheet compel increasingly risky financial behavior. So private sector
Speaker 1: actors are aware, either directly or implicitly, that we live
Speaker 1: in this balance sheet denominated world in which the only
Speaker 1: thing that sort of drives the cycle is the direction
Speaker 1: that asset prices are going in How does that change
Speaker 1: the behavior of households and firms when we when this
Speaker 1: is what drives the cycle, and how does it compel
Speaker 1: increasingly risky behavior? All right, we we identify nine ways
Speaker 1: where in which the expansion of balance sheet ratios has
Speaker 1: a higher debt to income and higher asset to income
Speaker 1: ratios actually change parameters in the economy that affect decisions.
Speaker 1: But I'll give you a very graphic illustration of what
Speaker 1: it looks like. First, uh I won't take you throw
Speaker 1: on nine. Don't worry, but the the don't check out
Speaker 1: the paper if you're listening. We've tried in the In
Speaker 1: the paper data from the uh I forget the of
Speaker 1: the organization, which the Pension Fund Association, and they show
Speaker 1: that the average target, that is what what the manager
Speaker 1: of that fund is supposed to be achieving on an
Speaker 1: average over the years, was just about just over eight percent.
Speaker 1: At that point, you could get almost a percent, about
Speaker 1: seven point eight percent on a thirty year Treasury didn't
Speaker 1: have to be very imaginative, taken a lot of risk
Speaker 1: in order to hit his target. Now, twenty years later,
Speaker 1: two thousand twelve, that target had barely moved was down
Speaker 1: slightly still about eight percent, Yet the yield on the
Speaker 1: third year bond was so Now how is he he
Speaker 1: can't just say, well, we'll buy some corporate or investment
Speaker 1: a little bit higher yield. Now now he has to
Speaker 1: they have to think of a whole different set of choices.
Speaker 1: There was quoting the I. M. F Uh making statement
Speaker 1: that we're having a problem with low interest rates because
Speaker 1: too many people are investing in in items, in assets
Speaker 1: that are too risky or too a liquid and this
Speaker 1: is going to lead to problems. This is exactly the
Speaker 1: dilemma that comes from balancing. Now again, we talked a
Speaker 1: little bit about interest racing forced down as balances get
Speaker 1: bigger and bigger, that the crises forced the Fed to
Speaker 1: lower rates to keep things stable. And we all also
Speaker 1: one of the things that happens as as as rates
Speaker 1: go lower, asset prices go higher. But what's the flip
Speaker 1: side of that low operating rates of return? If you
Speaker 1: have a low operator rates return, the rent on the
Speaker 1: building relative to the cost of building is low. The
Speaker 1: the dividends are stocks are you know, at a low rate.
Speaker 1: If you're looking to invest for conservatively for income, and
Speaker 1: maybe you'd have a little bit of blue chip equities
Speaker 1: paying paying UH dividends in the past with some investment
Speaker 1: create bonds. Now you can't do it that where you
Speaker 1: have to depend more on capital gains. So one of
Speaker 1: the things this does is it puts a lot of
Speaker 1: people investing in equities who really want UH steady income.
Speaker 1: And that's I think the origin of a lot of
Speaker 1: the pressure on on business managers to meet their quarterly
Speaker 1: objective for earnings and to put the emphasis there rather
Speaker 1: than what is good strategically for the long run. Right,
Speaker 1: I have a question how do people and I guess
Speaker 1: companies actually convert capital gains into you know, wealth or
Speaker 1: income or something they can use well for companies. First
Speaker 1: of all, companies will will sometimes have capital gates if
Speaker 1: they sell assets. In fact, it it's UH if we
Speaker 1: look at the period UH starting the nine we we've
Speaker 1: seen a lot of major capital gains by businesses that
Speaker 1: they've they've it's been a significant part of profits based
Speaker 1: on I r S data over over the decades. But
Speaker 1: you know, the most important capital gains are really the
Speaker 1: ones that are secured by the household sector. UH. And
Speaker 1: because how and and those capital gains have become larger
Speaker 1: and larger relative to income. We've also seen bigger and
Speaker 1: bigger cyclical swings in in the in assets, so that
Speaker 1: in other ways, the the the gains the wealth gain
Speaker 1: of relative to your income over a business cycle has
Speaker 1: become greater than it was in the past. And your
Speaker 1: wealth losses during the recession crisis have also become greater.
Speaker 1: So now you know we have another form of instability
Speaker 1: that that's that's uh imposed itself. But wealth effects also
Speaker 1: affect colleges and private private endowed entities where they have
Speaker 1: their own investments, where they have their own capital games,
Speaker 1: but also their donations are largely going to reflect the
Speaker 1: capital gains of of of So yeah, So on that note,
Speaker 1: how does asset price inflation um actually impact the balance sheet?
Speaker 1: And I'm actually thinking about corporates here, but there's been
Speaker 1: a lot of talk that that corporates borrowing from the
Speaker 1: bond market to fund dividend payouts and also share buybacks
Speaker 1: has inflated the value of equities. Is that something that
Speaker 1: you would buy into based on your thesis here, well, so,
Speaker 1: I mean that it was clearly happening the way that
Speaker 1: we see actually on the corporation's own balance sheet in
Speaker 1: terms of its own assets. Uh. That we see um
Speaker 1: asset inflation is usually in the form of goodwill, which
Speaker 1: comes about when they take over. They do a takeover.
Speaker 1: They they buy a company whose book value is five
Speaker 1: dollars and they pay two billion. Well, the access goes
Speaker 1: on as book value, uh sorry, as good will. The
Speaker 1: most acute places where we see these the acid of
Speaker 1: appreciation is I think in the household sector. It's also
Speaker 1: in in in the real estate commercial real estate sector,
Speaker 1: depending again which would cycle we're in. So let's get
Speaker 1: back to the original question. I mean, I remember like
Speaker 1: the first few years after the financial crisis two dozen
Speaker 1: ten or so, and my thinking, and arguably I would
Speaker 1: still say it is it's like, wow, that was really bad.
Speaker 1: But these things come along maybe twice in a century
Speaker 1: or once in a century, and then typically recessions are
Speaker 1: nothing like that. But we set up the whole discussion
Speaker 1: of like, well, can we actually just have this sort
Speaker 1: of shallow, short, not that bad recessions where there's not
Speaker 1: really a financial crisis and employment only rises a modest
Speaker 1: degree given what you've said, and ignoring about whether we're
Speaker 1: going to be in recession this year, next year or
Speaker 1: the year after that, because that seems hard to predict.
Speaker 1: How bad could it be? And are we naive to
Speaker 1: think that it could just be like a good old
Speaker 1: fashioned recession. Well, you know, moving from the principles that
Speaker 1: are illustrating this paper to put on a hat as
Speaker 1: my day, my normal day job, which is analyzing and
Speaker 1: forecasting the economy and looking at the world and trying
Speaker 1: to give opinions about it. What we see is in
Speaker 1: the United States. The United States was the epicenter of
Speaker 1: the last financial crisis. It was our housing bubble and
Speaker 1: the enormous um mortgage finance derivative monster sausage machine that
Speaker 1: we we generated and that had global implications. They were reflections.
Speaker 1: There were bubbles in other countries, but we were the
Speaker 1: center of it this time around. Uh, the United States
Speaker 1: is arguably no worse off and in some ways better
Speaker 1: off than it was going to the last secho. But
Speaker 1: the rest the world is in much worse condition. And
Speaker 1: I would say if we had there's no perfect analogy,
Speaker 1: but if I had to pick one thing to say
Speaker 1: it's this is this sector's housing bubble, I would say
Speaker 1: it is the emerging market sector. The emerging market sector
Speaker 1: has basically their their their boom over the past generation
Speaker 1: was largely based on tremendous growth and exports uh and
Speaker 1: also tremendous investment in their exporting capacity and infrastructures to
Speaker 1: support it. These countries were doing wonderful until they got
Speaker 1: to be too big a part of the global economy
Speaker 1: and the developed market economies started to slow down, and
Speaker 1: suddenly they couldn't keep doing this. So we've seen their
Speaker 1: investment weakening, their exports weakening, and increasingly they've they've been
Speaker 1: depending on incurring debt and basically being kept kept afloat
Speaker 1: by the tremendous search for yield that keeps money flowing
Speaker 1: into risky places. So we think in the next recession
Speaker 1: there could be serious problems in emerging markets, flights of capital,
Speaker 1: and its gonna be a real nasty mess. I think
Speaker 1: that will affect the world. So you say that in
Speaker 1: your view that you know, perhaps the best analogy to
Speaker 1: the housing bubble is what's going on in e M.
Speaker 1: One difference that really jumps out to me, however, is
Speaker 1: that people were bullish and enthusiastic about housing. Certainly still
Speaker 1: in two thousands six, maybe even it's still two thousands
Speaker 1: seven and then suddenly the entire edifice surrounding house they
Speaker 1: finance seemed to collapse overnight. Whereas with e M, e
Speaker 1: M sets have been under performing world markets for I
Speaker 1: don't know, close to a decade now. I think they
Speaker 1: peaked relative to global markets and have been under performing.
Speaker 1: It's extremely hard to find an e M bowl anywhere
Speaker 1: right now. They'll always say, you look at specific countries
Speaker 1: or you know, come up with some other thing, they say,
Speaker 1: and so should this be I don't know, give us
Speaker 1: a modicum of comfort. I mean, I'm not looking for comfort,
Speaker 1: but is it one that there is not a particularly
Speaker 1: high consensus that these countries are in great It's clearly
Speaker 1: not a perfect parallel. But I would say that what
Speaker 1: we've had in in terms of the underperformance, but we
Speaker 1: had the US, UH and Europe, the US with severe problems,
Speaker 1: and then the the the rest of the world. I sorry,
Speaker 1: Europe in particular with its crisis that it came out
Speaker 1: of at least largely came out of UM. So we
Speaker 1: had very rapid recoveries from those things UH and and
Speaker 1: and the long term problems I mentioned start to become
Speaker 1: more and more evident and weigh in the profit growth
Speaker 1: of those countries. So but I would maintain that there
Speaker 1: is still I mean, even even now there are plenty
Speaker 1: of people saying this is the time to rotate it
Speaker 1: to the MS just because they've underperformed. Uh. But the
Speaker 1: main place where the excesses, I would say, is the
Speaker 1: dead side, the number, the amount of death that's you know,
Speaker 1: the spreads are are still historically quite narrow as if
Speaker 1: there wasn't that much risk there. And yet there's another
Speaker 1: private sector hard money that mostly concerns you you mean
Speaker 1: the uh, the m private sector, private sector, and there's
Speaker 1: but there's also there's also a government. These governments because
Speaker 1: of the condition a lot of them being able to
Speaker 1: run deficit spending that they wouldn't be able to otherwise
Speaker 1: without worry about capital flight or having to raise interest
Speaker 1: rates or anything else. But also it's I want to emphasize. Look,
Speaker 1: we look at Europe. Their their debt ratio did not
Speaker 1: come down the way ours did in the last and
Speaker 1: it's higher than ours. So we look at Canada, they
Speaker 1: have the highest debt income ratio in the in the
Speaker 1: in the world. China very close, Australia close, South Korea
Speaker 1: is close, you know, so we have a lot of
Speaker 1: countries that have excessive balance sheets in one way or
Speaker 1: the other. It's it's more mixed. It's not like in
Speaker 1: some sense the housing bubble in the US was like
Speaker 1: it was a kind of a pinnacle. But but there
Speaker 1: are plenty of problems and and the thing is the
Speaker 1: United States has the institutions to u contain the damage,
Speaker 1: to stabilize this banking system when we have a crisis.
Speaker 1: Actually our currency strengthens, that's not it'll be a very
Speaker 1: different situation I think for merging markets. And that's that's
Speaker 1: why that's concerned. I have a step back question. I
Speaker 1: guess our Our previous guest on odd lots was Richard
Speaker 1: Coup from the Nomura Research Institute, and he's famous for
Speaker 1: coming up with the balance sheet recession idea, which is
Speaker 1: that basically, after you know, we get big recessions, it's very,
Speaker 1: very hard to get the private sector to lend again.
Speaker 1: People are sort of scarred by the experience, and even
Speaker 1: if interest rates go lower, they're not necessarily willing to
Speaker 1: go out and borrow. But you're sort of saying the
Speaker 1: opposite here. You're sort of saying that the reflexive reaction
Speaker 1: um is to continuously go out and expand your balance sheet.
Speaker 1: Why why do you think how do you account for
Speaker 1: that difference? Well, first of all, let's talk about who
Speaker 1: who's expanding their balance sheets. We're not seeing businesses go
Speaker 1: out to invest to expand capacity. The economy is not
Speaker 1: really the private sector is not investing in the profit
Speaker 1: sources are staying depressed. Where the money is being borrowed
Speaker 1: is in the financial sector, in people are trying to
Speaker 1: leverage positions to try to get more returns. I mean,
Speaker 1: there's always you know, there's borrowing in parts of the
Speaker 1: world going on their emerging markets. There their corporations who
Speaker 1: are in trouble who would be cutting back, but they
Speaker 1: keep borrowing to keep themselves afloat. Let me also just
Speaker 1: say generally, because you know Richard who really did a
Speaker 1: brilliant thing. I mean, coming from a conventional background, uh,
Speaker 1: he looked at the situation and in Japan and said,
Speaker 1: wait a minute, there's something going on here that that
Speaker 1: is not being accounted for. And he very properly identified
Speaker 1: the bubble in as having created over extended balance sheets
Speaker 1: and the process of bringing those balance sheets down was
Speaker 1: having all kinds of economic as well as just pure
Speaker 1: financial market of effects and a lot of his policy prescriptions.
Speaker 1: I I agree with that perfectly but large extent, but
Speaker 1: some point of thing that the balance sheets play a
Speaker 1: role in their expansion to contraction, plays a role in
Speaker 1: the economy throughout history, and that the balance sheets have
Speaker 1: had there's a long story here. This growth and balance
Speaker 1: sheets relative to income has made it possible, not only
Speaker 1: made it possible we get the point where we have
Speaker 1: these bubbles, but it started to generate its own pressures
Speaker 1: once you get to certain points of great, bigger and
Speaker 1: bigger bubbles each time until the whole thing breaks down. So,
Speaker 1: whether it's Richard Coop, many of the sort of MMT
Speaker 1: post Caynesians, Leftish economics types, and increasingly mainstream New Canesian
Speaker 1: types like Larry Summers, there is this growing consensus that well,
Speaker 1: to break this cycle that you described of lower and
Speaker 1: lower rates and more and more bloated private sector balance
Speaker 1: sheets and mediocre growth, what we really need is for
Speaker 1: all the developed market UH governments to step up and
Speaker 1: do true fiscal stimulus, really unleashed fiscal firepower. And of
Speaker 1: course we know that it's politically difficult because of politics,
Speaker 1: but in theory that's what could break this cycle? Is that?
Speaker 1: Do you agree with that? Is that? Ultimately what breaks
Speaker 1: what could break this cycle of larger and larger, riskier
Speaker 1: balance She's is if essentially more and more of the
Speaker 1: debt we're not at the household sector, not at the
Speaker 1: corporate sector, not in financial leverage, but in direct government spending,
Speaker 1: which is largely risk free, so that the debt swapped
Speaker 1: from risky private debt to largely risk free government sector
Speaker 1: debt um which is basically a safe asset. And if
Speaker 1: that were done in a concerted, large scale, sustained manner,
Speaker 1: would that break this sort of the bubble or nothing cycle.
Speaker 1: Here's the tricky part about it. The tricky part is
Speaker 1: if if, if you're the vision is that we get
Speaker 1: the whole global economy to be growing in a lovely
Speaker 1: manner supported by fiscal policy, and somehow these balancy successes
Speaker 1: will just fade away. No, they won't. You don't. As
Speaker 1: long as the economy as proceress, people are going to
Speaker 1: try to figure out how do we get higher returns.
Speaker 1: And if they're not there now, one of the things
Speaker 1: that happens if you raise interest rates, you tend to
Speaker 1: bring the asse advice down, but the negative wealth effects
Speaker 1: will be very powerful. The reality is governments are reactive.
Speaker 1: They're not you know, they're not gonna come up with
Speaker 1: a you know, a great, great move ahead of time.
Speaker 1: And I think what what we're likely to see is
Speaker 1: in the next recession we will see reliance on fiscal
Speaker 1: stimulus too, and hopefully associated with with long term investment
Speaker 1: and doing things that government has been neglecting in many places. Anyway,
Speaker 1: we have a whole lot of technology trend changes to make.
Speaker 1: We have to adapt to changes in how we use
Speaker 1: and create energy. So there's a lot of positive things
Speaker 1: that can lead to to a boom down the down
Speaker 1: the road. But I think you cannot escape the fact
Speaker 1: that the correction it's gonna it's not gonna be easy.
Speaker 1: People don't like to have their wealth go down. And
Speaker 1: in some sense, you know, we have created a fantasy
Speaker 1: with with with a great market enthusiasm and extremely low
Speaker 1: interest rates that somehow assets have an enormous value relative
Speaker 1: to the income they produce, which is just not really
Speaker 1: going to be sustainable. No, look, we're not This is
Speaker 1: not the end of the world. But I you know,
Speaker 1: I think we're gonna go through some some bumpy cycles,
Speaker 1: and and there will be I think I am worried
Speaker 1: about certain parts of the world that do not have
Speaker 1: the ability to to stabilize themselves. But but I think
Speaker 1: for the for the US, um hopefully we won't go
Speaker 1: through a recessions bad as the last one, but they're
Speaker 1: gonna be some bumps. So just just to be clear, though,
Speaker 1: can we ever go back to a ninety and fifties
Speaker 1: world in which the economy cycles are not driven by
Speaker 1: asset prices but are driven by income and production. I
Speaker 1: think I think we we are are, in all probability
Speaker 1: headed exactly to that, but I think we have to
Speaker 1: go through the corrector process. That corrected process means that
Speaker 1: we need to go through up here where asset prices
Speaker 1: are going to come down. Home prices have to come down.
Speaker 1: You know, if you look at Robert Schiller's UH chart
Speaker 1: on on the very long term UH real home prices,
Speaker 1: you see that we had a lot of stability for
Speaker 1: for throughout history. This enormous spike in the last cycle,
Speaker 1: we came down just back to the old highs, and
Speaker 1: we went up, not as big as spike, but they're
Speaker 1: still just too high. We need to adjust that equity
Speaker 1: evaluations have to be adjusted. That's gonna be difficult. But
Speaker 1: by the time we come out of this and this
Speaker 1: long period of week investment, the need to reinvest, the
Speaker 1: new technologies, the pressures, I think we're we're gonna, We're
Speaker 1: gonna come out of it, you know, but we probably
Speaker 1: have to be a little bit like the phoenix. We
Speaker 1: may have to catch fire a little bit before we
Speaker 1: we we we re birth. But not that's that's probably
Speaker 1: the right analogy. That's too extreme. I think in Japan,
Speaker 1: although it took them longer and they didn't do everything right,
Speaker 1: they did avoid a great depression, and I think they've
Speaker 1: they've healed a lot of their problems. What's your one
Speaker 1: recommendation to either politicians or policymakers about how to handle
Speaker 1: the big balance sheet issue and actually manage us into
Speaker 1: a place that is more similar to, you know, the
Speaker 1: nineteen fifties style of recession. Well, number one, there's no easy,
Speaker 1: clear roadmap, but here are four very quick rules. Number One,
Speaker 1: when you need to stimulate the economy, rely more on
Speaker 1: fiscal policy, hopefully for public investment. Number two, don't let
Speaker 1: the banking system break down. I think most of them
Speaker 1: get that, but but keep it functions. You can, you know,
Speaker 1: make the manage, the stockholders and the manager. You can
Speaker 1: punish them, but keep the banking system functioning. Number three
Speaker 1: is encourage orderly working out of problems when they're there.
Speaker 1: Resolution Trust Corporation for the same as loans a great example.
Speaker 1: And the final one is try to avoid and this
Speaker 1: is the real tricky when doing things like extreme monetary
Speaker 1: policies that that might lead to reinflating asset bubbles at
Speaker 1: a time you don't really want to be doing that.
Speaker 1: David Levy, this was a fascinating in conversation, and even
Speaker 1: though it's kind of depressing because you would have hoped
Speaker 1: that maybe two thousand two nine would have been that
Speaker 1: Phoenix moment, I am. I do appreciate that you left
Speaker 1: us on a little bit of hope that we're not
Speaker 1: all going to die. I think of the next generation,
Speaker 1: we're gonna see wonderful revival. I could go a whole
Speaker 1: laundry list of reasons why I think the US has
Speaker 1: got a very bright future. Uh, manufacturing coming back, all
Speaker 1: sorts of things having nothing, a trend that's already begun
Speaker 1: actually long ago. So it's not it's not all doom
Speaker 1: in globe but but but but the time for being
Speaker 1: a little cautious. Definitely. All right, Well, I really appreciate
Speaker 1: you joining on. I highly recommend everyone read your report,
Speaker 1: or if you don't read it, just check out the charts.
Speaker 1: They're great. Thank you very much, Thank you, Joe. Thanks David, Joe.
Speaker 1: I've on that conversation really really fascinating, not least because
Speaker 1: I personally have been thinking a lot about the financialization
Speaker 1: of the economy, though I think about it mostly in
Speaker 1: relation to corporates and UM I sort of alluded to
Speaker 1: it in the conversation, but M and A and buy
Speaker 1: backs and how that's interacted with asset valuations. But I
Speaker 1: really liked David's separate separation of corporate versus household versus
Speaker 1: government leverage, Like we tend to think of leverage as
Speaker 1: this one big, cohesive concept, but it actually has different
Speaker 1: effects on the economy. Of course. Yeah, I think financial
Speaker 1: media can often get extremely lazy about using the word debt,
Speaker 1: and it's like, oh, there's a lot of debt out
Speaker 1: there without we are the financial media, No, not using
Speaker 1: other people, but other people. And it is really important
Speaker 1: to distinguish between different kinds of debt, what's risky, what's productive,
Speaker 1: what is going to be a burden on the economy.
Speaker 1: And I just want to say, like I really, I
Speaker 1: don't think we intended it, but some of these last
Speaker 1: few episodes, I'm really into this balance sheet theme because
Speaker 1: we're of course talking to Michael Pettis and the structure
Speaker 1: of Chinese balance sheets, Richard Coude talking about the balance
Speaker 1: sheet recession where he sees it today, and then obviously
Speaker 1: getting more granular with David about different aspects of private
Speaker 1: sector balance sheets and this sort of ever inflating bubble.
Speaker 1: This feels like a really meadia topic and one that
Speaker 1: the mainstream UH is only now just starting to really
Speaker 1: come around and appreciate it. And like I said, you know,
Speaker 1: it's not totally outside the main stream. I think Jerome
Speaker 1: Powell hit on a couple of these things, and Jackson
Speaker 1: the whole a couple of years ago. But I'm I'm
Speaker 1: bullish on this is the topic. Well, a lot of
Speaker 1: these ideas sort of exist in the public sphere. I mean,
Speaker 1: David mentioned the I m F Report talking about you know,
Speaker 1: risky practices UH spurred on by low interest rates. They're
Speaker 1: all sort of out there. But what's nice about David's
Speaker 1: paper and his these this is that it all kind
Speaker 1: of pulls it together in a really tangible way. And
Speaker 1: we've actually inadvertently created a balance sheet series, which is
Speaker 1: quite cool. We have we have three three's a trend,
Speaker 1: yea trend. Alright, on that note, Alright, this has been
Speaker 1: another episode of the Odd Thoughts podcast. I'm Tracy Alloway.
Speaker 1: You can follow me on Twitter at Tracy Alloway, and
Speaker 1: I'm Joe Wisenthal. You could follow me on Twitter at
Speaker 1: the Stalwart. And you should definitely check out David's paper,
Speaker 1: The Bubble or Nothing, how private sector swelling balance sheets
Speaker 1: compelling increasingly risky financial behavior, really fascinating stuff. And be
Speaker 1: sure to follow our producer on Twitter, Laura Carlson at
Speaker 1: Laura M. Carlson and all the Bloomberg podcasts under the
Speaker 1: handle at podcasts. Thanks for listening,