I had another great conversation with with Dylan at Volitional Science Network. We talked about deficits, monetary policy, Weimar Germany, hyperinflation and what all of this means for Greece and the European Currency Union.
In a sovereign floating fiat money system, in particular under balanced trade or a trade deficit, government deficits are the only way the private sector can accumulate net private saving. As I’ve argued before, historical evidence shows us that there is a link between recessions and insufficient net private saving.
In this blog post economics professor L Randall Wray also presents an interesting historical link between government budget surpluses and ensuing Depressions in the United States. In particular, 6 out of 7 federal government budget surpluses were followed by a depression:
Since 1776 there have been exactly seven periods of substantial budget surpluses and significant reduction of the debt. From 1817 to 1821 the national debt fell by 29 percent; from 1823 to 1836 it was eliminated (Jackson’s efforts); from 1852 to 1857 it fell by 59 percent, from 1867 to 1873 by 27 percent, from 1880 to 1893 by more than 50 percent, and from 1920 to 1930 by about a third. Of course, the last time we ran a budget surplus was during the Clinton years.
The United States has also experienced six periods of depression. The depressions began in 1819, 1837, 1857, 1873, 1893, and 1929. (Do you see any pattern? Take a look at the dates listed above.)
The 7th time the US government ran a budget surplus was of course in the lead up to the 2001 crash and ensuing recession, and you could argue that it all ultimately culminated in the so called Great Recession of 2008-2009.
What I find helpful about investing in the permanent portfolio fashion, is that the assets observed together give you a good big picture overview of investors’ expectations about important macro data such as corporate profits, interest rates, and inflation.
The permanent portfolio consists of 4 equally weighted assets: stocks, gold, long government bonds, short government bonds (or cash).
We observe the following important movements since November 8th:
US stocks are now up about 6.2% since the election:
Gold is down about 8.2%:
Long government bonds are down about 8.5%:
On the short end rates are also up a bit as certainty a coming rate hike on December 14th has moved close to 100%:
To summarize: We have seen a selloff in safe haven assets like gold and bonds, and a surge in stock prices.
These are not hard and fast rules, but helpful for speculation:
Gold generally tracks consumer price inflation pretty well historically, but also becomes more desirable as a haven asset when expectations about corporate profits and interest rates on government bonds fall, diminishing the one big benefit that corporate stocks & bonds offer.
Long term government bond rates are a mix between government policy (bond buying or selling programs, future expected policy rates), corporate profit expectations (since high profit expectations encourage a move from bonds into stocks and low profit expectations do the opposite), and inflation expectations. While it is true that theoretically rates on government bonds in a sovereign floating fiat money system are entirely under the control of the sovereign government, most people including high level policy makers are unaware of this due to lots of misinformation on the topic, and we have to speculate accordingly, with that misinformation in mind. More on this in my post Why the National Debt Doesn’t Matter (And Why It Does).
Stock prices generally track investor expectations of corporate profits, but discounted by the rate on risk free government bonds. For example, you can see that since Q4 2014 corporate profits have trended down, yet stocks have actually edged up a bit over the period (even excluding the Trump effect post November 8th):
This can be explained by the observation that the rate on risk free options, namely long term government bonds, have also hit new all time lows in that same period:
So in summary, it looks like investor expectations of inflation remain low, while their expectations of corporate profits have jumped significantly, prompting them to sell gold and long bonds, while adding to their stock positions.
You can read more on the components contributing to aggregate corporate profits in this post about the Kalecki equation, which basically reveals that mathematically aggregate corporate profits can only be derived via the following spending/saving decisions made by different entities:
Corporate Profit = Investment + Dividends – Household Saving – Government Surplus + Export Surplus
There are several reasons why investors expect boosts to corporate profits, just to name a few:
Donald Trump has promised a significant corporate tax cut, which, all else being equal, will boost corporate profits noticeably. (In the equation above it would manifest itself in the form of a smaller government budget surplus or a larger deficit).
Furthermore, the elimination of arbitrary and scientifically unwarranted CO2 emission restrictions will likely boost domestic investment in oil, coal, and natural gas, which again, all else being equal, constitutes a net positive for corporate profits. (In the equation above this would affect the “Investment” component.)
It remains to be seen where household saving is headed, and also what happens to the trade balance, and other government spending programs which, if unmatched by tax hikes, could provide a further boost to corporate profits.
According to today’s update by the Federal Reserve US Household debt edged up by $112 billion in Q3 of 2016:
As you can see this is above the 2008 peak that kicked off the Great Recession.
However these are absolute numbers. If we look at household debt relative to personal income, we can confirm that household deleveraging continues:
Private debt = household debt + financial business debt + nonfinancial business debt. The ratio of private debt to GDP (or GDI) gives us an idea how indebted the US private sector overall is in relation to its income. And here, too, we observe that overall private debt deleveraging continues in Q3 of 2016, now at around 230% of GDI:
This is off very high levels, to be sure, so deleveraging may well continue for a while:
The level of private debt to income provides a snapshot of financial stability of private sector actors. A realization on the part of households or business that they are too indebted to repay debts can increase their liquidity preference and reduce private consumption and business investment demand as actors shore up their respective balance sheets.