posted March 8, 2018
A Theory of Systemic Fragility, Part 3 (from Chapter 19 of book, ‘Systemic Fragility in the Global Economy, Clarity Press, 2016

Financial v. Real Investment

Business economists and media commentators like to reference the ‘spread’ between long term and short term interest rates as indicative of the ageing business cycle and equity market expansion. The ‘spread’ between financial asset and real asset investing may represent a more important long run indicator of the economy’s trajectory.

The excess liquidity that leads to greater usage and leveraging of debt results in a convergence and thereafter subsequently a growing gap between financial and real asset investing over time. Liquidity, debt and leverage may expand real asset investment, when the periodic ‘fits and starts’ of such investment opportunities arise internally or externally. But the shift to financial asset forms of investing has proved to be more sustained over the last quarter century. Since 2000, financial asset investing has continued to accelerate, notwithstanding the abrupt ‘correction’ that occurred in 2008-09.

In contrast, real asset investing has continued to drift lower steadily since 2000, except for relatively brief surges related to oil-related capital spending, the opening of China to western investment capital inflows after 2000, and the emerging markets investment boom that followed. However, all these examples of real investment cycles have proved short-lived. The real asset investment that occurred after 2000 has been largely concentrated in these three areas—oil and energy, China, and emerging markets infrastructure and commodity development. By 2014-15, however, all three have clearly reversed and either slowed or contracted. Real asset investment is likely to slow even more over the coming decade.

In contrast, financial asset investment accelerated steadily and rapidly until 2008, only briefly contracted 2008-09, and then surged to further record levels since 2010 to the present. Should another financial crisis occur in the next five years, it may be deep but will likely be short again, as it was in 2008-09. Further liquidity injections by central banks and governments will no doubt occur in order to bail out the financial system, temporarily stabilizing it but in the process of bailing it out creating the conditions for another financial crisis later. But bailing out and jump-starting real investment and the real economy will not be as easy, even in the short run.

The ‘external’ or geographic expansion opportunities for restoring even the modest real asset investment growth rates of the past decade do not appear as likely as in previous decades. The former Soviet bloc, Chinese, and emerging markets opportunities for real investment are not repeatable. Perhaps Africa’s resources and the development of its infrastructure will fill that role, but the African potential is nowhere near as large as the others have been. As for ‘internal’ expansion opportunities, the physical assets needed for the new industries do not appear as great in terms of structures, equipment, inventories and other assets that will be required. The digital technology-internet-communications investment revolution that began in the mid-late 1990s was far more real physical asset intensive compared to the social networking, bio technology, and other candidates for real asset investment. Nor will the alternative energy investment opportunities result in a real investment surge similar to the tech surge. Alternative energy will have to be financed in large part by the government sector, as part of the predicted growth of government as share of GDP from around 20%-22% (in the US) to the 30%-35%. That will take longer and occur more slowly.

In contrast to this modest scenario for real asset investing, financial asset investment will continue to grow relatively, and in some cases absolutely, in size and total assets compared to real asset investing.

Facilitating that faster financial asset growth will be the new financial structures of institutions, liquid markets, and new financial securities, continuing financial product innovation, and the global network of the incredibly wealthy new finance capital elite that are now globally widespread and entrenched. It is estimated more than $100 trillion in investible assets are available in this global structure of institutions-markets-investor agents. Much of this wealth has been created from financial investing and speculation in the past. And it is not about to disappear or remain idle.

At the same time, central banks and governments have little alternative to continuing to pump more liquidity into the system in order to prevent the global banking system from collapsing. The system is now addicted to more or less free money. It cannot function if central banks raise interest rates to 4% or more. It remains simply too fragile.

Once envisioned as a brake on the shift to financial investing, the financial sector re-regulation that was launched in the wake of the 2007-09 global crash has been a dismal failure. What remains of token banking regulation in what were formerly, but no longer, the weakest sectors of global banking—the US and UK—have been and will continue to be dismantled piecemeal over time. It is a myth therefore that global finance capital can be regulated by any one country or government. Finance capital is like water running down hill; it eventually finds a way around government regulators.

Financial regulation is futile for another reason: the political changes in the advanced economy countries in particular have reduced general democratic influence while the influence of corporations, including bankers and investors, has continued to rise. That makes it even less likely that regulation of financial institutions will prove significant enough to check the next financial crisis, let alone slow the continued expansion of financial investing in the interim.

Liquidity injections by central banks will continue, as will more inside credit through the shadow bank system. Both will ensure the continued expansion of debt, and that means continuing debt will raise fragility in the system for years to come.

Given the almost certain long term continuing expansion of financial asset investing, and the corresponding continued slowing of real asset investing in the 21st century, the question arises: what are the consequences of this dual trend—for theory, for policy, and the trajectory of the global economy?

For theory, the dichotomy of investment raises the question: what is the causal relationship between financial asset and real asset investing? Is the slowing of real asset investing due to causes other than financial? Is the slowing driving the shift to financial asset investing; or is the rise of financial investing resulting in a slowing of real asset investing? Is it causality in both directions? If so, is it equal in determination? What is the process by which financial determines real, and real the financial? And what are the identifiable transmission mechanisms or variables. Transmission variables and processes are critical. Otherwise there is only a correlation between slowing real asset investment and rising financial asset investment, and correlations are too often misrepresented as causation.

The dichotomy of investment has significant implications for economic policy. If there is a shift from real investment toward financial assets that means less employment as well as employment at lower wage incomes. Real asset investment is more heavily weighted toward construction, manufacturing of producer and consumer goods, mining, industrial production, transport equipment and services, the inventorying and warehousing of goods, and research & development related services. Financial investing involves more professional services. The number of employed per dollar of investment is far less in financial than in real asset investing.

Consequently, the total income created is less as well. This means less household consumption as the household sector receives less of the total income created from financial asset investing—so insofar as the ‘bottom 90%’ receive little or no income from financial capital gains. Since financial transactions are hardly taxed, the slowing of real investment and subsequent decline of wage income and consumption translates into less tax revenue for government units as well. In other words, the shift to financial investing means a shift in income—from wage earning households and government units to financial institutions and wealthy investors.

Both households and government become more ‘fragile’, since fragility is a function of slowing or declining income from which to make payments on principal and interest from debt. This has a negative feedback effect. The slowing wage income gains for households means households often end up taking on more debt in order to maintain standards of living that otherwise fall from less earned income. Thus, consumption fragility rises for double reasons—slowing income and rising household debt. The same process takes place for government units, especially on the local level. Lower tax revenue collected leads to government units having to assume more debt (selling muni bonds by local government and Treasury bonds by national government).

These examples show that fragility can breed fragility within a sector (households or government) as declining income results in rising debt; and that the opposite may also occur—i.e. rising debt leading to declining income as future debt payments reduce future income streams. Whether due to rising debt loads, declining incomes, or both, fragility may also breed fragility between sectors. Should declining incomes lead to less consumption, it means less tax revenue income for government units and therefore an increase in that sector’s fragility factor as well. And if tax income slows, government units face a deficit and may have to borrow more to maintain spending levels. That means more debt and thus even more fragility.

One can immediately see the implications of all this slowing income growth and rising debt for government policy. Does the government raise taxes to restore income loss and avoid having to raise debt? If so, it may reduce its fragility factor, but only at the expense of raising fragility in the sector where taxes are raised (i.e. households or businesses).

More on these, and other, examples of feedback effects in policy and transmission mechanisms within and between fragility categories shortly. For the moment, it is evident that the growing dichotomy between real and financial asset investing that occurs as financial asset investing rises relative to real assets, has major policy implications.

Inflation-Deflation and the Two Price Theory

As for the implications of the financial shift for the trajectory of the global economy over time, the financial investing shift means not only important income inequality trends develop–with implications in turn for future economic growth that income inequality brings—but also important price trends result from the financing shift.

Slowing real investment means slowing productivity in goods production, cost cutting, further job cuts, slower wage gains, and less income. Less income suggests less consumption demand. At the end of this string of effects is goods deflation, which eventually emerges as consumption demand declines due to lower wages and income.

In contrast, the financial shift means more demand for financial asset products and therefore more asset price inflation. The demand-driven character of pricing for financial assets tends to feed on itself. Demand leads to price increases resulting in still further demand and price increases. In the case of financial securities, unlike goods prices, there are few offsetting supply and cost restraints to slow or dampen the inflationary tendency. Therefore, while goods prices tend to dis-inflate, and then eventually deflate, as a consequence of the financial shift, conversely financial assets tend to inflate and accelerate as financial bubbles emerge.

There is the added element, moreover, that financial asset price behavior appears more prone to inflationary expectations, compared to goods prices and expectations. Inflationary expectations appear to accelerate faster in the case of financial assets. The converse is also true, deflationary expectations play a larger role with financial assets.

The even more important question is how do changes in financial asset prices affect goods prices? And do changes in goods prices affect financial asset prices similarly?

So far as equity asset prices are concerned, it does appear that a rise in the price of a product for a particular goods producing company may reflect in a rise in that company’s stock price, at least to the extent the goods price rise results in greater profit. But we are talking here about aggregates, not individual prices for this or that product or even company. The question is whether the general price level for goods rises when financial asset prices rise. Since 2009, at least in the advanced economies, this does not appear the case. Goods prices have been disinflating and drifting toward deflation, while financial asset prices have been accelerating in stocks, bonds, and other financial securities. Nor does there appear to be strong correlations between financial asset inflation driving up the general price level for goods.

So during the boom phase, neither price system seems to determine the other very much. Financial asset prices may rise as the availability of credit in general expands. But after a point financial asset prices develop a dynamic of their own, rising as demand drives further demand, even as goods inflation slows. On the downside, in the case of deflation, however, financial asset deflation and goods deflation do appear to have a stronger mutual effect on each other.

For example, in the event of a financial or banking crash, as occurred in 2007-09, financial asset prices across the board—i.e. mortgage bonds, stock prices, municipal bonds, derivatives securities, etc.—declined rapidly. Liquidity froze up. Financial institutions withheld loans and corporate debt issuance dried up. With collapsed asset values on their balance sheets, banks and financial institutions refused to lend to non-banks and hoarded available cash and liquid assets, which were still insufficient to cover their deep financial asset price deflation and accounting losses. With no sources of lending for even their every-day operational loans, non-bank businesses cut costs—mostly wage costs via mass layoffs and other compensation freezes and reductions—aggressively and immediately. Suppliers were also cut off from payment, and had to follow with the same. At the same time as the severe cost cutting, non-bank companies attempted to generate more short term income by dumping their inventories and trying to undersell competitors by lowering their product prices. Just as the financial asset price collapse became a generalized phenomenon at the time, so too did the mass layoffs, cost cutting, and goods price cutting. The financial crash thus set in motion the process of real economic contraction that led to goods price deflation as well.

The opposite deflation effect—from goods to financial assets—is also more likely in the wake of a financial crash and consequent steep contraction of the real economy. This may occur directly and indirectly. In direct terms, declines in goods prices may reduce profits or other key business indicators, which may result in a decline in stock prices; or, reduced cash flow may raise concern by investors whether the company can make its debt payments. That causes the company’s bond prices to fall in turn, as its interest rate for obtaining new debt rises.

The process of goods deflation provoking financial asset deflation may occur more indirectly as well. For example, non-bank companies’ access to borrowing with which to finance operations declines rapidly during the initial recession contraction. Their available ‘income stream’ from sale of products serves as the main source from which to make continued debt payments, since further borrowing and debt is not available in this phase. But the mass layoffs that accompany the recession downturn sharply and quickly reduce household wage income and consumption. To entice demand from households, and ensure the necessary continued income-cash flow stream with which to pay debt, price reductions for goods becomes the remaining primary source of cash flow for continuing debt payments. And when many companies are attempting to do the same, goods price decline leads to more good price declines—i.e. to goods deflation. In this indirect manner, financial asset deflation can ultimately translate into goods deflation as well.

What’s further important to note is that these two processes—i.e. of financial asset price deflation eventually provoking goods price deflation and goods price deflation ultimately causing further financial asset deflation—is a mutual interaction. Both processes feed back on the other in a contractionary phase. There are two price systems and the two intensify their mutual reaction under certain conditions.

In other words, there is a dynamic and even dialectical process by which deflation in the one price system drives deflation in the other. This mutual deflationary process occurs primarily in the post-financial crash real economic contraction phase. The greater the mutual effect, the more the two price systems together intensify the contraction, each feeding off the other. When the deflation in financial assets becomes especially severe, it results in defaults. Financial asset prices may then virtually collapse, as courts and bankruptcy proceedings sell off the remaining assets by auction. Should enough defaults simultaneously occur, or defaults for highly visible companies occur, the psychological effect of fear of asset price collapse and contagion spreads to other companies causing other financial assets to decline more rapidly as well.

Understanding these mutual feedback processes is possible, however, only if one recognizes the fact of a ‘two price theory’ where financial asset price behavior is different than goods price behavior. Not all prices behave the same in relation to supply and demand. Not all price movements restore equilibrium, which requires the ‘supply and demand’ equilibrating assumptions based on pure competitive markets which do not exist. Mainstream economic theory, which does not recognize the ‘two price system’ idea, fails to explain how financial asset and goods prices interact, especially in the contraction phase. Nor does it address why, in the boom phase, financial asset inflation develops an independent dynamic of its own from goods price movements. But this is not the only error that mainstream economic analysis makes with regard to the role of price in financial instability and in precipitating great recessions and depressions in turn.

From Stagflation to ‘Definflation’

Economics has a term for declining real growth amidst rising inflation: it’s ‘stagflation’. It became common during the crisis of the 1970s. The term refers to ‘real’ variables—both GDP and goods prices. ‘Stagflation’ occurred when GDP slowed and declined while price inflation accelerated. That inverse relationship between GDP and inflation has reappeared, although this time the variables are not GDP and goods prices but goods deflation, on the one hand, and financial asset price inflation and aggregate valuation on the other. Perhaps another new term is necessary to represent the new ‘inverted relationships’, where financial asset prices inflate while goods prices disinflation and deflate. For lack of a better suggestion, perhaps ‘Definflation’ might be appropriate.

The emergence of stagflation in the 1970s posed a serious policy dilemma for economists. Prior to stagflation, if fiscal-monetary policy focused on economic stimulus and growth, then GDP could be expected to rise and unemployment decline. The trade-off was that goods inflation would also rise. If the policy focus was on reducing inflation, then fiscal-monetary policy would aim to contract the economy, reducing income and therefore demand for goods and lowering goods prices. The trade-off was more unemployment. But 1970s stagflation discredited that theory. Fiscal-monetary stimulus would not reduce unemployment but would increase inflation further, and fiscal-monetary policies seeking to slow the economy, made unemployment worse without reducing prices. Policy was stymied. Something similar is the problem today. Monetary policy is attempting but failing to prevent the slowing of real investment and the drift to deflation in goods prices, while simultaneously boosting financial asset investment and inflation.

The consequences for the long term trajectory of the global economy are serious. How can we halt the drift toward goods deflation if monetary policy primarily boosts financial asset investment and inflation and not only does little to halt goods deflation, but may actually contribute to it? How can we restore real asset investment to prior growth rates when increasing liquidity leads to financial investing since it is potentially more profitable and holds other advantages as well? Can the growing problem of income inequality be resolved by token adjustments to wage incomes, even as real investment is slowing and financial capital gains and capital incomes from financial profits are accelerating? How is it possible to slow and reverse the shift to financial asset investing, inflation, and redistribution of national income to capital incomes at the expense of wage incomes, without a fundamental change in the size and class policy orientation of government? And without major damage to financial sectors?

Economists are at a loss to explain how to get out of the policy dilemma of deflation amidst inflation today in 2015, just as they were in the prior crisis in the 1970s as to how to get out the ‘stagflation’ policy contradiction. That leads to a related subject and debate that is also associated with the shift from real to financial asset investing worth briefly commenting upon.

The Irrelevant ‘Money Causes Inflation’ Debate

Just as in the 1970s when they debated somewhat futilely whether there was in fact a policy tradeoff between inflation and employment, since 2008 mainstream economists have been continuing to debate whether the excess money supply (i.e. liquidity) injections by central banks will lead to excessive inflationary pressures at some point.

The one wing of mainstream—who are called in chapter 16 ‘Retro-Classicalists’—argue that Federal Reserve policy will eventually result in runaway inflation. The other wing—the ‘Hybrid Keynesians’—argue there is no evidence this is occurring or will occur. Both are wrong, and both are right. Which means both are confused. The ‘Hybrids’ (liberals like Paul Krugman) are correct that the massive money injections have not led to goods inflation. In fact, goods prices continue to drift lower in the US, are still lower in Europe and Japan, and are even slowing in China. Krugman of course refers to goods inflation. But Krugman’s error lies in not addressing financial asset inflation, which has accelerated rapidly due to the record liquidity injections. The ‘Retros,’ (conservative Monetarists like John Taylor), insist on goods inflation coming around the corner (or the next, or next). But Taylor is also ignoring financial asset inflation. In other words, both Hybrids and Retros are fixated on goods prices and ignore financial asset prices, when it is the shift to financial investing that is ultimately responsible for both financial asset inflation and goods disinflation-deflation. Both continue to debate the effects rather than the causes, in other words.

Neither wing of mainstream economics—Hybrids or Retros—understands that the explosion of liquidity and debt that is driving mostly financial investing, and less so real asset investing, is leading to a drift toward deflation in goods prices, while stoking inflation on the financial side. The goods deflation trend suggests not only that most of the central bank-provided liquidity in recent years is flowing to financial investing, but that it is also likely redirecting a certain amount of central bank liquidity away from real investment to financial, for reasons previously explained.

Liquidity As Brake on Real Growth

The excess liquidity created since the 1970s—over and above what real investment has been able to absorb—has been flowing into financial asset investment. It has become far easier to create additional liquidity than it has been to find real investment outlets for it. The amount of liquidity has been so massive, and the growth of related debt levels so rapid, that governments and their central banks have been losing control of both—excess liquidity and incessant debt creation. Not surprisingly, the shift to financial investing has followed.

After having unleashed finance capital in the 1970s and 1980s to address the crisis of the 1970s, to expand capital globally to open new markets, to establish the unstable alternative to the Bretton Woods international monetary currency and trading regime, the system has not been capable of containing, managing or regulating the excess liquidity nor the excessive debt creation that has erupted in turn.

The historic contradiction is that the liquidity explosion set in motion in the 1970s is becoming a brake on economic growth it is supposed to generate. The massive liquidity and the ever-rising debt it has created have become a destabilizing force for the system, as financial asset investing crowds out real asset investment, and in turn is generating a host of related problems like chronic low job creation, stagnant wage income growth, weak consumption trends, slowing productivity, drift toward goods deflation, rising income inequality, and constantly emerging financial asset bubbles worldwide.

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