Macrofugue Analytics

I – The Nominal and the Real

In economics, there are two kinds of problems:  real problems and nominal problems.

The deforestation on Easter Island destroyed most of the Rapa Nui.  When it was necessary to leave the island and start new lives in a new land with an environment able to support their people, there were not enough large trees left to build ocean-worthy vessels.  Their population declined to 15-20% of their peak population within a century.

This is an example of a real problem. A real problem is a lack of natural resources, capital goods, land or labour, or when any combination of these factors of production sum to an inadequate value to produce enough to maintain (or better) the general welfare of a people.

A nominal problem is one which is contained in the abstract.  They can result from frictions in capital structure, uneven distribution of income, or simply in the collective choices of participants in an economy.

The wealth contained in an economy is its capital stock:  our oil fields, forests, farms, houses, offices, cars, computers, factories, data centers, software and construction equipment.  Our potential is richly governed by the quantity of our workers, the durability of their work ethos coupled with their experience and education.  This is the real economy.

Capital consists of raw materials, instruments of labour, and means of subsistence of all kinds, which are employed in producing new raw materials, new instruments, and new means of subsistence. -Wage Labour & Capital (Marx, 1847)

II – Marginal Capital Allocation

An economy with inadequate capital has firm prices and high capital returns.  An economy with a glut of capital has soft prices and low capital returns.

Economic growth is the expansion of capital – and subsequent expansion of capital utilization. Investment creates capital. Capital is the accumulated labour directed by the formation of financial capital.  This capital, or accumulated labour, represents capacity to sustain consumption.

High (low) capital returns don’t necessarily equate to high (low) capital prices.  An outsized capital return likely indicates that additional investment will be induced, which could compete to drive the price of its output down.

Growth in employment hinges on investment.  The utilisation of existing capital maintains the stability of existing employment, but new employment requires new investment.  This is demonstrated with Figure 1, showing a very strong relationship between the health of the employment market and Investment net of Capital Consumption as a fraction of GDP.

Figure 1: Variations in Net Investment explain 92% of unemployment from 1990-on.

Unemployment is largely a result of rentierism, which we’ve defined as the behavior of collecting economic rent from existing assets instead of creating new ones. The act of collecting rent is a preference executed on marginal free cash flow dollars, principally by the corporate sector.  Corporate Management have three options, with increasingly expected yield requirements:

1. Hold it as cash:  this is a liquidity preference, which is pro-cyclical, and becomes decreasingly attractive as the embedded put option in cash becomes too expensive to hold while it decays, thus becoming less competitive with capital accumulation options that have a positive real expectancy
2. Purchase existing capital:  this can be either the purchase of used or previously existing fixed capital, such as machinery or real estate, or capital assets, including a firm’s own stock
3. Invest in new capital:  building a new factory or drilling a new oil well

III – The Marginal Rentier Opportunity Curve

J. M. Keynes (and Irving Fisher before him) furnish us with the Marginal Efficiency of Capital as the excess return of a piece of capital over its supply price.  The supply price can be one of two values:  the market price (buying used or existing capital) or replacement cost (new net investment).

I define the marginal efficiency of capital as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price. This gives us the marginal efficiencies of particular types of capital-assets. The greatest of these marginal efficiencies can then be regarded as the marginal efficiency of capital in general. The reader should note that the marginal efficiency of capital is here defined in terms of the expectation of yield and of the current supply price of the capital-asset. It depends on the rate of return expected to be obtainable on money if it were invested in a newly produced asset; not on the historical result of what an investment has yielded on its original cost if we look back on its record after its life is over. -General Theory of Employment, Interest & Money (Keynes, 1933)

There in fact exist marginal efficiencies between all investment opportunities.

Figure 2: The Marginal Rentier Opportunity Curve outlines the yields on principal investment opportunities available for the marginal cash-flow dollar

I propose, approximately illustrated in Figure 2,  the Marginal Rentier Opportunity Curve, which offers a comparison between the principal investment opportunities available. The current yield is not the same as the Expected Return.  We can, however, tease out the relative expected returns by spreading spots on this curve.

The investment opportunity set has ascending and encapsulating risk premiums:  Attractiveness of new investment is measured against the sum of all premiums between it and the risk-free rate.

Thus, I further propose:  The price of capital is the Net Present Value of Risk-adjusted Expected Return discounted from the Marginal Rentier Opportunity. 

 IV – Used Capital Competition

So far, I have postulated:

1. The wealth of an economy, and the capacity for its income, is contained in the accumulated labour, or the capital stock, of its people.
2. Economic growth, measured by real income, is the accumulation of labour and subsequent utilisation through net new investment.
3. The marginal investment dollar purchases either existing capital assets, or the creation of new capital assets through net new investment.
4. Marginal investment dollars that are not allocated into net new investment cause a reduction of income to the household sector, and increase unemployment.

Assuming the aforementioned postulates true, it can be observed that the rational business manager will, perhaps simultaneously:

1. Increase liabilities from portion of the Marginal Rentier Opportunity Curve with the lowest expected return.
2. Increase assets from the portion of the Marginal Rentier Opportunity Curve with the highest expected return.

This necessarily implies that, if the risk-adjusted expected return is not highest in net new investment, the business manager will instead invest the marginal dollar into existing capital. If the price of capital is the Net Present Value of Risk-adjusted Expected Return discounted from the Marginal Rentier Opportunity, and the business manager finds the most attractive investment opportunities in the purchase of existing capital, we can conclude:  the price of existing capital must be bid up high enough in order for new capital to be competitive.

V – Jobless Recoveries

Figure 3: The relationship between Net investment as % of GDP as 12-month payroll growth

The significance of existing capital available cheaply to allocators is that, until existing capital is expensive enough to make new capital competitive, net new investment will be muted, and so too will employment growth (figure 3).

The common understanding is stocks lead the economy at economic turning points.  This is not always true.  Coming out of the .com bust, the economy bottomed in 2001, more than a year before S&P 500 finally did.  The explanation is expectations lead the economy, but I find this argument runs counter my observations in expectations around cycle turns.  I offer an alternative: that which causes equities to (typically) bottom is also what causes the economy to recover.

The recovery after the .com bust recession was termed a jobless recovery, and for good reason:  jobs took even longer than the stock market to bottom!

Figure 4: The jobless recovery following the .com bust

Using our understanding of job-growth as net-investment driven, we can clearly see why there were no jobs:  there was no investment.  The next observation we can make from Figure 4 is the lack of investment, even years after the recovery, until after the S&P 500 had bottomed.  Finally, in later 2003, the Net Investment is elastic to the upward movement in the S&P 500.

For this argument, we approximate the S&P 500 as the aggregate price-level of existing capital.

The inference is that the jobless recovery of late 2001-2003 was the result of a net investment-less recovery, which was probably the result of existing capital being available more cheaply.

We can see the same pattern emerge, as demonstrated by Figure 4, in the present recovery.

Figure 5: The second jobless recovery

Perhaps most incredibly, Net Investment went negative for the first time in history of the series going back to 1947 during The Great Recession (figure 6).  Our capital stock was depreciating at a greater rate than we were replacing it.

Figure 6: The long-run relationship between Net Investment and growth in employment

The explanation that jobless recoveries result from a scarcity of net-investment because existing capital is too cheap for new capital creation to be competitive enjoys intuitive sense, as well some recent historical evidence.

VI – Contemporary Interpretation

If the price of existing capital has been rising, and Net Investment has been muted, we conclude that the price of creating new capital is not competitive with existing capital.

The great irony is that, the richer the country has become, there is less work to be done, which leaves workers with less income.  This is our great nominal problem.

Figure 7: Labour force and population growth projections through 2050

Figure 7: Labour force and Private Non-Residential Fixed Investment growth

The CBO and BLS forecast around 0.7% annual labour force growth this decade, and just 0.5% in the 2020s.  This means the growth of future requirements for fixed capital and accumulated labour that support workers — such as office buildings or automobiles — will be subdued, even more so than the production of goods consumed by all demographic groups.

Combined with productivity efficiencies in the Internet age that provide a declining Real Capital Intensity of Economic Output, we require less capital formation.  This potentially explains why the price of real capital had been below its previous peak for so long, and consequently why net investment (and employment growth by proxy) has been limited.

With the S&P 500 (our approximate aggregate capital market value) closing once again near record highs, it seems likely that new investment will be more attractive.

Perhaps Conor Sen put it best:  Wringing the risk premia out of existing capital is a necessary precondition for new capital formation (and hiring!).

I hope and believe we are there, and maybe we’ve learnt something new about the nature of jobless recoveries.

As we discovered before, the marginal decision on cashflow re-allocation drives cyclicality.

There are principally three types of capital allocation transactions.

If you are expanding capital stock, or you are funding the expansion of capital stock, you are investing.  This includes net fixed investment, the purchase of newly issued marketable securities which fund new investment, or otherwise funding ventures which do. Purchases of existing shares on the secondary markets, such as the purchase of stocks and bonds outside of IPOs do not represent investment, but simply swapping the ownership between the cash and security holders.

If you are underwriting convexity risk to capture theta, you are providing liquidity. You needn’t be doing this with options.  Any portfolio instrument or stance that pays an expected time premium for adopting convexity risk will do, whether it be buying a stock which has a temporary disconnection from fundamentals or shorting volatility instruments.

If you are doing neither, you are simply trying to exploit a monopoly on existing capital.  This can be accomplished by owning existing fixed capital assets and selling the output, or by ownership of securities which stake a claim in ownership of existing fixed capital assets and income.  The value of existing capital is relative to the supply of existing real capital to meet present demand for output.  This is most profitable when there is an existing deficit of real capital from inadequate past investment relative to present demand.  The value is bolstered by the frictions to competition by new investment to expand capacity.

While investment is the only non-rentier transaction type, the provision of liquidity, particularly during times of market dislocation, generates value by raising the unrealised equity value of other holders, thereby freeing their capital to service something more productive.  However, if the liquidity provider previously had liquidity preference — that is, he developed his monopoly on capital by first hoarding it through non-reinvestment accumulation — this reverts to unproductive behaviour on balance.

The decision to allocate like a rentier is not entirely autonomous.  There is a realistic limit to the amount of fixed capital which can be profitable and manageable by the agency of a single individual or household.  The purchase of securities (or shares) to defer the management of fixed capital thus also defers the decision to be a capitalist or a rentier.

Interest in rentierism has begun to percolate in the last few years.  I propose a framework for analysing and discussing the modern state of rentierism in the terms of behaviours, incentives and empirical impact on the economy.

Both the capitalist and the rentier seek to exploit their monopoly on capital to acquire more capital.  Rentier behaviour is typically found in households and corporations, with the public sector tending to run deficits to support the former two.

The distinction between the rentier and capitalist is that the capitalist reinvests her cashflow into creating new capacity – or new real capital.  The rentier more simply exploits his existing monopoly on capital for cashflow.  The capitalist accumulates new real capital, which expands the nation’s capital stock while rentier accumulates economic rent.

All other things equal (including return on capital), it is preferable to be a rentier.  The capitalist creates new things, and is constant competition with other capitalists to provide the highest quality cost goods and services at the lowest cost.  Because capital reinvestment is risky, return on capital is generally lower for collecting economic rents.

The fulcrum upon which the capitalist and the rentier are defined is the marginal decision to re-invest cashflows.

Unchecked, a reduction of re-investment subtracts income from the rest of the economy. When this happens in aggregate, the labour which was used to create the production won’t be able to purchase all of their own output.  Rentiers thus reduce labour demand and demand for the output their assets produce.

Figure 1: Saving as a % of Investment = Unemployment Rate

To approximate the Aggregate Rentierism in the econonmy, we look at the fraction of savings that investment comprise of.  We observe in Figure 1 that Gross Private Savings as a % of Gross Private Investment explains 70% of the unemployment rate. Rentierism is unemployment.

Figure 2: 85-country study regressing age against saving and investment

Rentierism itself is not morally objectionable.  The gap between savings and investment is explainable through demographics.  The relationship between age and both income and investment is well understood.  The young have little income and large risk appetite.  As they approach middle-age, their income and investment peak.  At the onset of old age, the high-income dramatically reduce investment to save with less risk towards retirement.  Retirees then dis-save and liquidate investments for sustenance.  Figure 2, drawn from Saving and Demographic Change: The Global Dimension (Bosworth, Chodorow-Reich), demonstrates this effect empirically.

Figure 3: Savings Rate over Age

The agents which make these decisions, even if impacted by household demographics, aren’t always households themselves, but we’ll start there.

Based on the 2011 Bureau of Labour Statistics’s Consumer Expenditure Survey, we imputed household a savings rates across age-groups using the difference between Income Before Taxes and Average Annual Expenditures.  This is an approximation, and we just use the shape of the curve in our analysis.

The shape of this curve intones a marginal propensity to accumulate rent based on demographics.  Can we really blame our middle-aged for saving with less risk for retirement?

Not all savings are accumulated equally.  The Bureau of Labour Statistic’s Personal Savings Rate accounts for Fixed Investment as consumption, whilst the Federal Reserve’s Z.1 Flow of Funds report reports that as a form of saving.

Figure 4: Consumer Expenditure Survey data on age-groups

Both are valid in their own context.  The Z.1′s F.10 subsection details the breakdown, including comparison to the Bureau of Labour Statistics version.

The difference between the two provide the basis for rent-seeking savings and capitalist savings.  The capitalist household saves by creating new fixed capital, while the rentier household savings in cash and financial assets.  Thus, we find the household decisions that drive rentier behaviour are probably principally driven, at least over the long-run, but demographics.

Cyclical swings in the marginal propensity to save also invoke the paradox of thrift: when everyone saves, aggregate demand falls, and so too does income, and the value of assets frequently fall more than the cash balances increase.

Households aren’t the only agent which demonstrates rent-seeking behaviour.

Figure 5: The fraction of income which is reinvested into capex

Using historical data from the F.101 series of the Federal Reserve’s Z.1 Flow of Funds release, we form a ratio between Income before taxes and Capital Expenditures (figure 5).  We find something which looks strikingly like long-term government interest rates.

Business capex to income is proportionate to long-term government interest rates.

This draws us to our central conclusion: rentierism is a dependent derivative of capitalism.  A positive risk-free rate is the ultimate vehicle of the rent-seeker.

We can see that the cost of money is proportionate to the level of re-investment.  This infers that a high cost of money is dependent on a high level of re-investment.

Figure 1: Labour Force Participation Rate and Non-farm Payrolls

Has the United States of America reached, and perhaps passed, “peak capitalism” – the point where the maximum number of people participate in capitalist relationships?

The argument could be made, at least on a relative basis, that it has indeed crested, and we are on the slow, inevitable march away.

Let’s back pause a minute to define what this means:  Capitalism is the system of relationships between the labour class and the capital class.

Individual relationships are really bilateral.  There are two channels:  the wage channel, whereby the capitalist negotiates with the worker for the highest output at the lowest salary, and the price channel, whereby capitalists compete with one another to provide the highest quality products and services for the worker at the lowest prices.

The capitalist does not do this at a loss.  She endeavors to maintain an advantage between her expenditures and sales – her profit.

This system provides a unique suite of incentives to each class which is responsible for providing the West a previously unimaginably high standard of living, even for the lower classes.  The worker is incentivised to produce more and higher quality goods, thereby increasing his advantage in competing with other labour for higher wages.  The capitalist is incentivised to produce higher quality goods at lower prices, thereby increasing her advantage in competing with other companies for sales, and ultimately the capital she can accumulate.

The worker seeks to consume the highest quality of goods at the lowest prices, and the capitalist seeks to accumulate more capital.

Figure 2: Wages as fraction of nominal GDP

By looking at this (now well worn) chart of Wages as % of GDP (figure 2), it could be assumed that a net capital advantage has been accruing over time. There are other things that support this view.  I would prefer to use U.S. mean family net worth by percentile of net worth to really show how this capital accumulation has played out.

Figure 3: Mean family net worth by percentile of net worth

However, if you add Government Social Benefits to Wages as % of GDP to the former chart, the picture changes dramatically!  The present value, 58%, is dead from the 1959-present average.

Figure 4: Wages and Government Social Benefits as a fraction of nominal GDP

The character of change now represents a shift, not from labour to capital, but away from the classical capitalist bilateral relationship between the labour class and the capital class (through wages and prices) to a unilateral one (prices).

Thus we get to the fundamental reality:  capitalists have been compensated for serving the poor and the elderly.  The system has worked for everyone.  The government has brokered a deal whereby capitalists accumulate capital by providing the infirm and the retired working class sustenance.  Perhaps you would change the proportions of profit and transfer payments, but the basic system of transactions and incentives has been proved out.

The facilitating mechanism is the Federal government’s ability to add new financial assets (money and Treasuries) into the system.

Let’s apply the shift in bilateral capitalist relationships with a simple example: The legacy of the labourer’s work is not just the modest sum which he was able to accumulate, but also in the accumulated labour his employer captured as surplus value.  This accumulated labour is the combination of technology utilisation and process improvement which enabled his employer to produce more goods at the same cost – an improvement known as productivity.

When the worker retires, the government subsidises his means of sustenance by crediting new deposits to his bank account.  He uses these credits to purchase sustenance from the capitalist class.  The retired worker has already pre-paid for these newly government-created deposits with the massive productivity gains throughout his career.  As long as the retired worker, and the present labour force, are able to increase productivity at a rate faster than the retiree’s new deposits are created by the government, the capitalist gets paid, her worker is employed, and the retired worker is provided sustenance.

At the most basic level, the worker does not pre-pay his retirement through social security and pension fund contributions, but even more so by productivity.  He has pre-paid in through continually improving his employer’s capital and use of capital to expand output at the same cost throughout his career so the government can print money to deposit in his account after retirement without causing inflation.

The inevitable decline in per-capita working-aged people mean that the nature of capitalism fundamentally shifts away from the bilateral capital-labour transactions to a more complex set of transactions, introducing a third party – the public sector – to broker the deal.

The enemy of both capital and labour in the system of capitalism is running out of new markets.  Wages are not paid out of the current production of employees, but from past production by capitalists with the expectation that they will produce a surplus of value over what they are paid (for why else would the capitalist make this transaction?).

Figure 5: Change in savings rate with more wealth and income

Were it to stop here, the amount of money and income circulating through the economy would contract.  Capitalist income has long since maximised consumption, and is now focused on maximising capital accumulation.

At this point, this capitalist has free cashflow.  There are two actions she can do with it:  she can keep the cash, or re-invest it into more production.

Since capitalist’s goal is to accumulate more capital, she is going to re-invest when she sees opportunity, and this free cash-flow is exchanged with new labour for more future production.

But what happens when the capitalist sees her opportunity set decline?  Her expectation that the payment she makes to the new workers she’d hire would materialise into higher revenue later diminishes, and she decides to book her profit as cash.

Figure 6: Investment/Savings Ratio bears a strong relationship to the unemployment rate

Who could blame her?  She isn’t going to operate at an anticipated loss.

Let’s analyse why our capitalist would view her re-investment returns pessimistically: The first is the shift in near-term investment expectations.  Assuming new markets will always become available, the only reason to withhold investment is the worry that the market value of your capital will decline in the short-term.  The investment time horizon moves from “what is the total return on this piece of capital until it is consumed?” to “will I be able to get the same price for this piece of capital tomorrow that I can get today?“.

We have previously observed that these variations in investment horizon — and consequently rate of investment — are responsible for most of the economic cyclical variations.

The second is a glut of capital relative to the population.  There appear to be two chief reasons for this:  a rapid expansion in technology-driven productivity and demographically-driven declining final sales growth.

Let’s analyse what the capitalist does when there is a glut of capital:  Returns on capital are too low to create new real capital, so the capitalist’s objective turns from accumulating more capital to collecting and retaining economic rent by exploiting the monopoly she has on existing capital.  Our capitalist has now turned into a rentier.

Collecting economic rents siphons income from the rest of the economy, reducing the amount of income available to labour to purchase its own output.  As is, the rentier now has lower final sales, thereby reducing her perception of future returns on invested capital.  Her marginal proclivity shifts further into fiscal retrenchment. Unchecked, this scenario is not good for any of our three classes:  the labourer is out of work or has less income, the capitalist sees her sales (and utilisation of her existing capital) decline, and the retiree still requires sustenance.

Rentierism does have a derogative connotation.  Capitalists get paid to take investment risk while expanding capital stock, and labours get paid for their time.  Rentiers profit simply by having a monopoly on existing capital.  But if we examine their incentives, can we blame the capitalist for shifting to a rentier?  She certainly has the right to try to avoid losses.

The way to mitigate the transition pain from capitalism to rentierism is to have the government pay retired workers for years of uncompensated productivity gains.

We can see a prior example of of a rapidly increasing dependency ratio and glut of capital in the past 20 years of Japanese economic history.  Germany is not far behind.

Consider life in these two high dependency ratio countries:  They have very low unemployment rates and low inflation rates.

Figure 7: Old-aged dependency ratios for the United States, Japan and Germany

The principal political driving force away from bilateral capitalism to trilateral government-brokered rentierism will, perhaps ironically, be the same force that is trying desperately (and likely with futility) to hang on to more capitalist relationships:  baby boomers.  But even the conservative baby boomers will move to ensure their entitlements are maintained, for they will need more than they anticipated as a result of the 2008 crisis.

We have been shifting at the margins away from bilateral capitalist relationships for decades.  What replaced it has successfully navigated the needs and demands of each class – accumulation to capital for enterprise value, sustenance to workers for labour and sustenance to the retiree for decades of productivity growth.

The key will be formalising how this already works so we can adjust policy within the framework for the betterment of every American.

Investment: Driver of Cyclicality

GDP, the measure of the nation’s income, is the sum of 4 components:

Y (GDP) = C (Consumption) + I (Investment) + G (Government Spending) + (X [Exports] – M [Imports])

The most volatile component is investment.  The cyclical variation of the economy could be said to largely be driven by investment.

We put Gross Private Domestic Investment in a vector autoregression framework with Real GDP, and ran an Impulse Response Function analysis on it to measure the impact of of the marginal change in investment on the real economy.

The answer was interesting: for every 1% y/y increase in nominal investment, real growth increased by 1% y/y by for several quarters after, the effect falling to 0 (and, roughly equilibrium) after 6 quarters.

Given GDP averages 6.39x the size of investment, investment wields substantial leverage over the economy.  The equilibrium is achieved when the investment is simply rolled into future real GDP.  The real capital has been created, and the means to utilise it have been pre-spent into the economy.

We should probably pause and define investment.  Deploying capital to stocks or bonds isn’t investment – rather, it is simply allocation of savings.  Investment activity either creates un-sold consumables (inventory stock), or increases the real capital stock (houses, machines, factories).

What incentivises investment?

Impulse response function of Real Retail Sales %-y/y on Gross Private Domestic Investment %-y/y

The answer is simple:  the expectation that there will be demand for the output resulting from the investment.  That expectation is established from realised demand.  That is:  demand begets investment, which begets more demand.

Investment in the business cycle

A recession could potentially be characterised by the preference for liquidity (saving) over investment or consumption.  What is rational for individual actors is not necessarily rational for the aggregate.

Counter-cyclical spending stablises aggregate demand, the anchor to which marginal investment decisions are made from.

At the same time, gross capital formation provides support in activity with consumption of fixed capital.  Despite a downturn in economic activity, as long as the expectation isn’t for a prolonged depression and permanent output impairment, capital goods are replaced when worn out.

Thus are the evident levers of power over the economy.

Benjamin Franklin wrote a piece in 1729 entitled A Modest Enquiry into the Nature and Necessity of a Paper-Currency.

The contents of which surprised me a great deal.  Ben Franklin champions ideas that are attributed to Marx, Keynes and others 150-250 years later.  Not only was his command of economics impressive, but Franklin’s writing was an order of magnitude better than Marx, and quite a bit more accessible than Keynes.

Because it’s a great deal longer than a typical Macrofugue post, I’ve emboldened the paragraphs which I think are particularly compelling.  If you don’t have the time to read the whole thing, at least skim those.

Benjamin Franklin:

THERE is no Science, the Study of which is more useful and commendable than the Knowledge of the true Interest of one’s Country; and perhaps there is no Kind of Learning more abstruse and intricate, more difficult to acquire in any Degree of Perfection than This, and therefore none more generally neglected. Hence it is, that we every Day find Men in Conversation contending warmly on some Point in Politicks, which, altho’ it may nearly concern them both, neither of them understand any more than they do each other.

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Figure 1: Personal and mutual fund cumulative acquisition of corporate equities

In the jilted age of cynicism towards our institutions, the enormous success of capitalism over the past 60 years can be summed into the above chart.  It represents the cumulative effect of households systematically investing in equities, and then selling them at higher prices.

Figure 2: Personal cumulative acquisition of equities and mutual funds

Secondary to this story is the continual shift away from direct equity ownership into mutual funds.

What is most striking, however, is the fact that the non-financial corporate sector has operated almost entirely without outside capital for the past decade:

Figure 3: Cumulative Net Capital raised 2000 to now

Contrast this the 90s, where equity issuance went negative in the latter half, but companies still raised capital on the credit markets:

Figure 4: Cumulative Net Capital Raised 90s

You haven’t spent much time on the finance blogosphere if you haven’t seen the conspiracy theories surrounded evaporating trading volumes.  The simple fact is that companies have contracted equity supply.

Moreover, the need for outside capital has nearly vanished.

Fiscal and Monetary Policy Accommodation model estimate

While not the only driver of economics and asset returns, policy-making has a great deal of influence over growth and prices.  In order to estimate its effects, we generalise both monetary and fiscal policy to a percentage which represents how loose or tight policy is at a given point.

We do this by regressing coincident macro variables against policy outcomes, and subtracting the realised policy outcomes from the model.  The residual leaves us with the relative tightness of policy which contributed to the growth outcomes for that time period.

A neutral (0%) policy stance does not represent zero growth, but sample trend growth, +2.5%.  Ergo, slightly negative (tight) values do not necessarily indicate a negative growth stance.

The reasons for recession and growth extend far out the generalisation of policy relative tightness.  Policy-making really just shapes what trends deliver at the margin.

The chief observation is that, relative to the economic variables, fiscal policy actually has been tighter under the Obama administration than under George W Bush.

F1: Per capita Initial Claims now in most desirable 30% of historical readings

With leading indicators like per-capita initial claims edging into the top 30% of all desirable readings (figure 1), the unemployment rate at a post-recession low of 7.8%, and the S&P 500 now less than 10% from its pre-bust peak, the question we now have is: what now?

We have been waiting for the labour, asset and home markets to clear for three and a half years.

For most of it, the United States seemed like it was slipping into the same class of economic malaise that Japan had suffered, and a close cousin to that of The Great Depression.

The policy response, both fiscal and monetary, seemed to only stem the tide to provide relief from the most acute effects, while the underlying economy was left in the muck.

It takes time for markets to clear after great disequilibrium.  “Green shoots” began to appear in early 2010:  inventories had been drawn down to unsustainably low levels, and governments internationally, having learnt something from studying The Great Depression, had prevented a death spiral.  Overtime increased to compensate for the low inventory levels.  Production rose.  Then payrolls began to return.  The corporate cash hoards began to invest, if not in new capacity, in greater efficiency.  Lending standards incrementally eased with employment fundamentals.

F2: New Privately Owned Housing Unit Starts %-y/y vs Real GDP %-y/y

While the United States saw asset markets clearing with progressive improvement, the labour, credit and housing markets had been stubbornly over-supplied.

The past few months have provided a strong indication that those markets are finally clearing.

The principal question now is whether the US economy will continue to muddle through, or whether the pace of market clearing will lead to more a more virtuous cycle.

We examine auto sales and new home starts (figure 2) because they provide evidence of spending with multiplicative effect, which is the favoured fuel for the virtuous cycle fire.

F3: Inflation converges on Wage-growth

The next step in recovery is for the pace of wage-growth to recover.  As we’ve already established, consumer price levels are governed by wage levels (figure 3).

We previously observed that the rate of wage-growth actually falls in the first leg of a recovery.  Our hypothesis is that the first group of employees to be hired back have minimal bargaining power.

F4: Layoffs & discharges as % of the civilian labour force

The relative bargaining power labour has to command higher wages may be on its way to increasing.  The percentage of labour force which was laid-off & discharged is presently at historical lows.  At 1.05%, only 11% of readings are lower (figure 4).

Indeed, the skills gap which exists in that unemployed buffer stock may in fact slow down employment growth at the same time as the already-employed command higher wages.

F5: The relationship we observe between the unemployment rate & wage-growth is not Wg = -Ur, but rather Wg = 1/Ur

Examining the relationship between unemployment and wage-growth (figure 5), we observe that (Wg = -Ur) is not true, but rather that (Wg = 1/Ur).  This is a significant observation:  the convexity of wages in price/wage spirals behave like any other commodity against supply limits with short-run inelastic demand.

To view this relationship between payroll growth, we normalise Non-farm Payrolls %-y/y and Personal Income %-y/y, and observe a leading relationship.  The result is somewhat surprising – is indicative of much higher

F6: Normalised payroll growth and personal income growth

Personal Income growth (figure 6).

It may be even more surprising that the bond market is also predicting somewhat higher wage-growth and inflation than at present.

This is not reflected in the absolute yields, or real rates net of inflation or wage-growth, but is visible in the 1s2s5s10s Treasury curve (figure 7).

This curve is one of the few things that has forecasting value over future wage-growth.  The sharp decline in wage-growth looks very much like the mid-80s, and the temporary deviation between wage-growth and the Treasury curve was followed up by a strong increase in

F7: 1s2s5s10s leads Wage-growth

wage-growth pace.

The recovery portion of this economic cycle has been dreadfully slow.  For some time after the recession officially ended, it appeared we would never see growth again.

Swinging into a higher pace of wage-growth will close out the first chapter of this economic cycle.  Demographics and capital structure will probably make for unimpressive mid-cycle growth, but so far, we really have been following the script of a recovery — just very slowly.

There is still political risk.  Japan attempted to cut back government spending, and combined with the Asian financial crisis, it set them back a decade.  The analogue between the United States and Japan, however, diverges in two key places:  the demographics of Japan are far grimmer than in the United States, and the bubble was much larger.

It still may take some more clearing in employment, credit and housing markets, but the table has been set to transition from recovery to mid-cycle.  Wage-growth climbing back up above the 2% level will be the sign I’m looking for to turn the page.

Time has not been generous enough to allow for any writing recently.

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