The work of the great economist Joseph Schumpeter (1883-1950) has always resonated. When I ponder analytical frameworks pertinent to these extraordinary times, none are more germane than Schumpeter’s Business Cycle Analysis. Best known for “creative destruction,” Schumpeter’s seminal work materialized after experiencing the spectacular “Roaring Twenties” boom collapse into the Great Depression.
Contrary to Milton Friedman and Ben Bernanke, Schumpeter didn’t view the twenties as the “golden age of Capitalism.” Depression was a consequence of egregious boom-time excess rather than the result of the Fed’s post-crash failure to print sufficient money. Schumpeter possessed a deep understanding of Credit; he keenly appreciated the roles entrepreneurship and risk-taking played during booms. Schumpeter also understood Capitalism’s vulnerabilities.
“Whenever a new production function has been set up successfully and the trade beholds the new thing done and its major problems solved, it becomes much easier for other people to do the same thing and even to improve upon it. In fact, they are driven to copying it if they can, and some people will do so forthwith. It should be observed that it becomes easier not only to do the same thing, but also to do similar things in similar lines… This seems to offer perfectly simple and realistic interpretations of two outstanding facts of observation: First, that innovations do not remain isolated events, and are not evenly distributed in time, but that on the contrary they tend to cluster, to come about in bunches, simply because first some, and then most, firms follow in the wake of successful innovation; second, that innovations are not at any time distributed over the whole economic system at random, but tend to concentrate in certain sectors and their surroundings.” Joseph A. Schumpeter, Business Cycles, 1939
“The American debt situation and the American bank epidemics… are in a class by themselves. Given the way in which both firms and households had run into debt during the twenties, the accumulated load… was instrumental in precipitating depression. In particular, it set into motion a vicious spiral within which everybody’s efforts to reduce that loan for a time, only availed to increase it. There is thus no objection to the debt-deflation theory of the American crisis, provided it does not mean more than this. The element it stresses is part of the mechanism of any serious depression. But increase of total indebtedness at the rate at which it had occurred in this country is neither a normal element of the mechanisms of Kondratieff downgrades nor in itself an ‘understandable’ incident, like speculative excesses and the debts induced by these. It must be attributed to the humor of the times, to cheap money policies, and to the practices of concerns eager to push their sales; and it enters the class of understandable incidents only if we include specifically American conditions among our data. Similarly, bank failures are of course very regular occurrences in the course of any major crisis and invariably an important cause of secondary phenomena…Those epidemics cannot, however, be considered as wholly explained by the ordinary mechanism of crises or by the mechanism plus the fact of excessive indebtedness all round or even by all that plus the stock exchange crash. The American epidemics become fully understandable only if account be taken of the weaknesses peculiar to the American banking structure…” Joseph A. Schumpeter, Business Cycles, 1939
We live in extraordinary, unprecedented times. The timing of the COVID-19 pandemic – on the heels of an unparalleled period of synchronized global economic growth; a record-setting U.S. economic expansion; and worldwide financial and asset price booms – ensures far-reaching financial, economic, social, political and geopolitical ramifications. COVID Strikes Mercilessly at Peak Fragility.
Fragilities have been mounting across economic and financial systems – at home and abroad. The pandemic is pushing many over the edge. Not only are central banks and governments fighting the immediate effects of the coronavirus, they are these days in epic battle against Business Cycle Dynamics. In particular, bursting Bubbles have central banks more determined than ever to do “whatever it takes” to fulfill their so-called “price stability” mandate.
There were deflation worries following the 1987 stock market crash. Deflationary risks were key to the Greenspan Fed’s aggressive early-nineties stimulus measures (and championing of “Wall Street finance”). Global deflation fears were acute during the 1997 bursting of the “Asian Tiger Bubbles” and even more so the next year with the Russia/LTCM collapse. Dr. Bernanke joined the Fed in 2002 after the “tech” Bubble collapse, as the Fed formulated a major push against the scourge of deflation. After the bursting of the mortgage finance Bubble, global bazookas were mobilized for an all-out assault against deflationary forces.
Of late, a nuclear arsenal has supplanted the impotent bazookas. I’m convinced policymakers are “fighting the last war” with perilously misguided armaments. The Schumpeterian framework supports my case.
The past 25 years accomplished the greatest period of innovation and technological advancement since the “Roaring Twenties.” Concurrently, the world experienced an unparalleled period of financial innovation – specifically a historic shift from traditional bank lending to a system dominated by market-based finance and central bank intervention. Real economy innovation fueled finance, and financial excess stoked entrepreneurship and risk-taking. In combination, innovation in both real economies and finance fueled historic changes in financial and economic structure.
The Federal Reserve has essentially employed highly accommodative monetary policy for the past thirty years. After beginning the nineties at about 450, the Nasdaq Composite traded this past February to an all-time high 9,838 (closing Friday at 9,121). Except for a few fleeting periods of instability, free-flowing finance has supported (“cluster” upon historic “cluster” of) innovation. The Credit expansion has been unrelenting, with Non-Financial Debt surging from $10.5 TN to begin the nineties to today’s $55 TN.
Central bankers are these days keener than ever to fixate on their inflation mandate and targets. That inflation dynamics have evolved profoundly over recent decades is apparently not worthy of discussion. The impetus is to stimulate more aggressively than ever.
Schumpeterian “clusters” – explosive innovation and adoption of new technologies – have altered the nature of contemporary output, economic structure and inflation dynamics. Incredible expansion of technology hardware, software, digitized output and related services fundamentally altered the economy’s structural capacity to readily expand the supply of output. What started with the low-cost personal computers mushroomed with the adoption of the Internet. The past decade’s unprecedented monetary stimulus and booming markets saw frenzied multiplication of innovation “clusters” (i.e. Internet-based products, “cloud”-related services, “Internet of things,” robotics, biotech and pharmaceuticals, alternative energy, the “sharing economy,” autonomous vehicles, and so on).
Technological innovation and adoption help explain why aggressive monetary stimulus and system-wide “loose money” have not been associated with higher consumer price inflation. A veritable endless supply of “tech” output readily absorbs any additional purchasing power making its way into the real economy.
Meanwhile, mounting Credit and speculative excess primarily fueled inflation in asset prices and Bubbles. Moreover, this combination of booming finance and asset markets provided major impetus to U.S. economic structural mutation. Deindustrialization took root, with American manufacturing suffering at the hands of cheaper imports. Meanwhile, booming financial markets and surging household wealth propelled a structural shift to a services-based economy. A confluence of U.S. financial innovation and excess, policy experimentation, economic restructuring and resulting massive Current Account Deficits propelled “globalization” – and, with it, systemic Global Bubble Dynamics. In the process, inflation dynamics were fundamentally and momentously transformed.
If things seem too good to be true, they probably are. There are critical issues associated with current inflation, financial, economic and policy structures. The COVID-19 pandemic is illuminating many.
Let’s start with inflation. With global Bubbles bursting, there will be associated downward pressures on some price levels (i.e. energy and commodities). Demand will wane for many products and services. Yet broken supply chains are pushing some prices higher. Meanwhile, the world is afflicted with unprecedented debt burdens.
Central bankers are fully committed to doing “whatever it takes” to drive aggregate consumer inflation up to target. The nature of inflation has evolved profoundly, yet central banks adhere to the doctrine of a general price level that they can manipulate higher through monetary stimulus. This capacity for policy measures to inflate THE general price level is fundamental to the view that consequences of Credit excess and market Bubbles can be readily mitigated. And this gets to the heart of this dangerous flaw in contemporary economic doctrine: that boomtime Credit and financial excess can, for the most part, be disregarded. Asset inflation and Bubbles are to be ignored (promoted?), focusing instead on preparation for aggressive faltering-Bubble reflationary measures.
In reality, deflation is a symptom – a consequence. The problem is excessive debt, speculative leverage, asset market Bubbles and deep economic structural maladjustment. Importantly, there is today no general price level to manipulate higher to inflate out of debt and structural problems. Aggressive reflationary efforts will instead only add to unmanageable debt loads, while further straining financial and economic structures. As we’re already witnessing, Trillions of Fed “money” creation ensure market and price level instabilities. Moreover, stimulus measures at this point dangerously exacerbate wealth inequality, and with it social, political and geopolitical instability.
From the New York Times (Nelson D. Schwartz, Ben Casselman and Ella Koeze): “People with the least education have been hardest hit in the downturn… The unemployment rate for workers without a high school diploma stood at 21.2% in April, compared with 8.4% for those with a college degree… Workers earning under $15 an hour account for more than one-third of job losses, far beyond their share of the work force.”
And from the Washington Post (Heather Long): “What’s clear so far is that Hispanics, African-Americans and low-wage workers in restaurants and retail have been the hardest hit by the job crisis. Many of these workers were already living paycheck-to-paycheck and had the least cushion before the pandemic hit. ‘Low-wage workers are experiencing their own Great Depression right now,’ said Ahu Yildirmaz, co-head of the ADP Research Institute… The unemployment rate in April jumped to a record 18.9% for Hispanics, 16.7% for African-Americans and 14.2% for whites.”
We’re witnessing a down-cycle at Pandemic Mach One. Twenty million jobs lost in April. Yet the S&P500 returned almost 13% during the month. The Nasdaq Composite surged 15.5%. Much would remain ambiguous in a typically gradual downturn. Not so with COVID-19. There are no subtleties and little complexity– it’s clear for all to see.
How can much of society not be convinced Federal Reserve support primarily benefits Wall Street and the wealthy? If you are employed in the service sector, odds are you’re facing terrible hardship. If you are fortunate enough to work for Amazon, Microsoft, Google, Apple, Tesla, Netflix, Zoom, or even most tech or biotech companies – with your stock and option grants you’ve likely rarely done better. Covid-19 is laying bare the stark inequity of the current structure. The “trickle down” argument, having remained tenable during the long boom, has in six weeks been blown completely out of the water. “Dow Ends Week 455 Points Higher, Shaking off the Worst U.S. Unemployment Rate Since the Great Depression.”
Federal Reserve Credit rose another $65.5bn last week to a record $6.664 TN, pushing the nine-week gain to a staggering $2.519 TN. M2 “money supply” (with a week’s lag) expanded another $333bn, with a nine-week rise of $2.059 TN. Institutional Money Fund Assets (not included in M2) added $25bn, boosting its nine-week expansion to $946bn.
Meanwhile, a magnitude 5.2 earthquake struck this week along the European Fault Line.
May 6 – UK Telegraph (Ambrose Evans-Pritchard): “Germany’s top court has fired a cannon shot across the bows of the European Central Bank and accused the European Court of breaching EU treaty law, marking an epic clash of rival judicial supremacy. In an explosive judgement, the German constitutional court ruled that the ECB had exceeded its legal mandate and ‘manifestly’ breached the principle of proportionality with mass bond purchases, now topping €2.2 trillion and set to rise dramatically. The bank had strayed from the monetary realm into broad economic policy-making. The court said the German Bundesbank may continue to buy bonds during a three-month transition but must then desist from any further role in the ‘implementation and execution’ of the offending measures, until the ECB can justify its actions and meet the court’s objections. It also said the Bundesbank must clarify how it is going to sell the bonds it already owns. ‘For the first time in history, the constitutional court has found that the actions and decisions of European bodies overstep their legitimate competence, and therefore have no validity in Germany,’ said the court’s president, Andreas Vosskuhle. No country has dared to do this before since the creation of the Community in 1957. It is a revolutionary moment for the European project. Olaf Scholz, the German finance minister, said the court had set ‘very clear boundaries’ and that Europe would henceforth have to find other ways to keep monetary union on the road.”
May 5 – Bloomberg (Stephanie Bodoni): “The European Union’s top court faced the most stinging attack in its 68-year history — not from Brexiteers, but from its German counterpart. In a long-awaited ruling on the European Central Bank’s quantitative easing program, Germany’s constitutional court in Karlsruhe accused the EU Court of Justice of overstepping its powers when it backed the ECB’s controversial policy. The German court said the EU judges’ December 2018 ruling that QE was in line with EU rules was ‘objectively arbitrary’ and is ‘methodologically no longer justifiable.’ It gave the ECB a three-month ultimatum to fix flaws in the measure. ‘This is a declaration of war on the ECJ, and it will have consequences,’ said Joachim Wieland, a law professor at the University of Administrative Sciences, who sees the real challenge in the future relationship between the EU court and national constitutional tribunals. ‘It’s an invitation for other countries to simply ignore decisions that they don’t like.’”
May 8 – Reuters (Gabriela Baczynska): “The European Union’s top court said on Friday it alone has the power to decide whether EU bodies are breaching the bloc’s rules, in a rebuke to Germany’s highest court, which this week rejected its judgment approving the ECB’s trillion-euro bond purchases… ‘In order to ensure that EU law is applied uniformly, the Court of Justice alone – which was created for that purpose by the member states – has jurisdiction to rule that an act of an EU institution is contrary to EU law,’ the court said in a statement.”
May 7 – Financial Times (Martin Arnold): “Christine Lagarde has fended off criticism of the European Central Bank’s government bond purchases, saying she was ‘undeterred’ by an order from Germany’s highest court to produce a justification of its action. Speaking publicly for the first time since its flagship bond-buying policy was challenged by the German constitutional court, the ECB president said the pandemic meant the Frankfurt-based institution — as well as other central banks — ‘have to go beyond the normal tools to use exceptional measures . . . to avoid a tightening [of financing costs] and to ensure our monetary policy is transmitted across the euro area’. ‘We are an independent institution, answerable to the European Parliament, and driven by our mandate,” she said… ‘We will continue to do whatever is needed, whatever is necessary, to deliver on that mandate. Undeterred.’”
Christine Lagarde is undeterred. For the most part, markets remain undeterred (though European yields rose this week). Likely business as usual for the Bundesbank for the next three months. But then significant uncertainty. Once again, COVID-19 timing is awe-inspiring. While Germany’s Constitutional Court ruled previous QE was not categorically illegal monetary financing, the latest $800 billion Pandemic Emergency Purchase Program (PEPP) clearly crosses the line.
Things appear headed in the direction of a real mess. Timing unclear. German Constitutional Court vs. European Court of Justice (ECJ). Additional lawsuits out of Germany challenging “whatever it takes” PEPP ECB QE. Other national courts – and governments – emboldened to flaunt sovereignty and challenge a weakened European Union. Germany’s Bundesbank is in a tough spot, split between the German Constitutional Court (along with its sound money principles) and its role as the largest member of the ECB. Does the ECB continue “disproportional” support for Italian debt markets, inviting a confrontation with Germany’s Constitutional Court? Does the Italian debt market begin fretting a world with less certainty of unlimited ECB buying? This week saw a meaningful chink in the armor of European monetary integration.
“It is of the utmost importance to realize this: given the actual facts which it was then possible for either businessman or economists to observe, those diagnoses – or even the prognosis that, with the existing structure of debt, those facts plus a drastic fall in price level would cause major trouble but that nothing else would – were not simply wrong. What nobody saw, though some people may have felt it, was that those fundamental data from which diagnoses and prognoses were made, were themselves in a state of flux and that they would be swamped by the torrents of a process of readjustment corresponding in magnitude to the extent of the industrial revolution of the preceding 30 years. People, for the most part, stood their ground firmly. But that ground itself was about to give way.” Joseph A. Schumpeter, Business Cycles, 1939
Original Post 9 May 2020
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