Policy Tensor

Measuring The Financial Boom

In Markets on February 23, 2015 at 6:26 pm

This morning’s Economist espresso served up a warning on the current asset price boom. The US and UK’s stock markets are at record levels; Japan’s is at a 15-year-high; and the EU’s is at a 7-year-peak. The asset price boom is the result of central banks’ extraordinarily accommodative policies. The prospect of economic recovery in the US has added fuel to the fire. But just how overvalued are stocks? And what is the extent of the financial boom?

The Case-Shiller cyclically-adjusted price-earnings ratio (CAPE) is a good measure of the general level of stock price valuations. CAPE’s long-run average of 16.6 is sometimes taken as a benchmark. I have never found that satisfactory. The ratio uses the 10-year moving average of earnings as the denominator. Expected future earnings may easily be considerably larger or smaller depending on whether one is coming out of a long recession or a long war, et cetera. Still, at 28, the CAPE has already crossed the level prevailing before the crisis.     


There is another reason the policy tensor is dissatisfied with CAPE. It only looks at the stock market. But a financial boom may migrate from the stock market to other assets and back. The current financial boom extends far beyond the stock market. In particular, bonds seem to be overvalued as well. One can’t simply throw in corporate bonds and divide it by earnings. That is not a meaningful ratio since interest payments get deducted from earnings. In order to come up with a meaningful ratio, one must find a suitable denominator.

I have found just such a measure that I call the balance sheet ratio. For the numerator we choose the total liabilities of US nonfinancial firms, including equity and debt. For the denominator, I selected total capital stock of all US nonfinancial firms, available from the Bureau of Labor Statistics. This includes all productive assets of US nonfinancial firms. One can think of the firms using these assets to generate revenue from which they have to pay both their bondholders and their shareholders. The total liabilities of firms, equity plus credit, must be serviced by their future revenues. The idea is that if the price of assets get bid up excessively, it should show up in a higher balance sheet ratio.

Balance sheet ratio

Should we expect the balance sheet ratio to stay constant over time? The short answer is no. One should expect the ratio to rise over time if the return on deployed capital, firms’ physical and intellectual assets, is increasing over time. The chart below shows both the balance sheet ratio and the return on capital deployed. We can see that the return on deployed capital has been rising since 1990. And that this rise accelerated in the 2000s. 

Balance sheet ratio and capital income

I regressed the balance sheet ratio on the return on capital deployed. I performed two regressions. The first with the 1990-2012 data and the second with 2000-2012 data. The number of observations in the second regression is too low to give us much confidence. Moreover, due to the asset price boom of the 2000s, the predicted values are overestimates. Still, I provide charts of predicted vs. actual balance sheet ratios for both. 



Whether or not we trust the second regression, the implications of both are the same. As a sanity check we look at another ratio, balance sheet to GDP:

balance sheet to gdp

A fairly coherent picture emerges from these charts. The size of corporate balance sheets is unwarranted by fundamentals. The balance sheet ratio measures both the stock market boom and the credit boom. No matter how you slice and dice it, we are in the midst of a major financial boom. 

Inflation’s Mysterious Vanishing Act

In Markets on February 16, 2015 at 6:53 pm


The most important macro development of the past few decades has been the banishing of inflation from the center of the international economy. In the United States, we know that Volcker’s draconian policy measures were decisive in bringing down inflation from its 1980 peak of slightly over 12% to under 4% by 1983. But the Fed has been extraordinarily accommodative since at least 2000, yet core inflation has been under 3% since 1995. What accounts for this startling fact?

In standard macroeconomic textbooks, the general price level is determined by the money supply. Broadly speaking, the rate of inflation equals the difference between the rate of growth of the money supply on the one hand, and the rate of growth of real output on the other. This basic picture is adjusted when there is an ‘output gap’ captured by the concept of the ‘natural rate of unemployment’—in the technical jargon, the non-accelerating inflation rate of unemployment (NAIRU)—defined as the level of unemployment consistent with stable inflation. The GDP equivalent of full employment is the absence of an output gap. Excess demand bids up the price level and increases inflation; deficient demand likewise results in lower inflation. Note that this refinement is contingent on monetary accommodation: you can’t have high inflation unless the supply of money grows rapidly.

The standard model fails miserably in making sense of the past twenty years. Not only does it fail to predict the magnitude of the decline in inflation; much more damningly, it gets the direction of the movement wrong. In light of the extraordinarily accommodative monetary policy, it predicts rapidly accelerating inflation. What, then, accounts for inflation’s vanishing act? And why does the standard model fail so miserably?

The argument that central bank discipline is responsible in not persuasive on two grounds. First, inflation has been tamed not just in the United States and not just in the core of the world economy, but globally: world-wide inflation has declined from double digits to around 4% over the past twenty years. Therefore, central banks’ institutional learning can hardly be said to provide an efficient explanation. Second, and fatally, center countries’ monetary policies during the past twenty years can hardly be described as restrained. Any good explanation must account for the global nature of the phenomena and the failure of ultra-loose monetary policy to unleash inflation.

Back in 2003, Kenneth Rogoff argued that globalization is to blame. Specifically, he argued that “the most important and most universal factor supporting world-wide disinflation has been the mutually reinforcing mix of deregulation and globalization, and the consequent significant reduction in monopoly pricing power.” He is right about globalization but wrong about the mechanism. Inter-firm competition in product markets for tradable goods and services, whether national, through deregulation, or international, through increasing trade openness has indeed been responsible for disinflation in the periphery, but this is not the case in the core of the world economy. Rather, I will argue that the explanation for disinflation in the core of the world economy has to be sought inside firms. Specifically, the unbundling of firms’ supply chains allowed them to pit national labor pools against each other, sharply reducing their ability to bargain for higher wages, and thereby short-circuiting the central mechanism that drives persistent inflation.

A number of facts have to be digested to appreciate the centrality of the mechanism I have identified:

1. Wage inflation is the principal driver of persistent inflation. This is in fact the key premise of the concept of the non-accelerating inflation rate of unemployment (NAIRU). Business cannot raise prices without a significant growth in consumers’ purchasing power. Unless the Federal Reserve sends cash-strapped consumers a check in the mail, consumers can only increase their spending on goods and services by becoming ever more indebted. But there are inherent limits to credit-fuelled expansion in consumer spending: it is not enough to generate significant inflationary pressures. Persistent inflation is well-nigh impossible without a sustained rise in nominal wages.

Wage inflation

2. The Federal Reserve does not control the money supply. This may come as a shock since in both macroeconomic theory and common parlance, the Fed can choose to expand the stock of money at will. But this is a fallacy. It is the banks who create money out of thin air. When you apply for an auto loan, your bank makes an accounting entry on its books showing that you owe it $20,000 and debits $20,000 to your account enabling you to buy the car. To be quite clear: the bank loaned you $20,000 that did not hitherto exist. It is therefore clear that the amount of nominal dollars floating around depends on general credit conditions; crucially, it depends on borrowers’ ability to borrow and lenders’ ability to lend. The Fed merely manipulates the constraints on banks to lend by manipulating the federal funds market. The federal funds market is only the last resort for banks who satisfy the bulk of their funding needs through the repo market and the offshore market in eurodollar bank deposits. In fact, the reality is even more sobering. What we have is a ‘market-based credit system’ in which the money supply emerges from a complex interaction of the monetary authorities, the behaviour of banks and shadow-banks, and general credit conditions. The Fed can hardly be described as quarterbacking the operation, much less choosing the money supply. 

3. Credit expansion in the absence of any significant growth in wages is, and can only be, absorbed in the asset markets. The reason is straightforward. In light of their depressed incomes, people’s capacity to borrow is inherently limited. Books may be fudged for a while and subprime lending expanded but sooner or later this process will reach its limit. Unless, of course, there is an asset price boom that raises the value of the collateral on which lending can expand. Both of these dynamics were in play before the financial crisis. More generally, extraordinarily accommodative monetary policy buoys up the price of risky assets by prompting a ‘search for yield’ by asset managers. Credit expansion thus gets channeled into rising asset prices. 

4. The collapse of wage inflation in the 2000s can be traced directly to the ‘second unbundling’ of firms’ supply chains. In particular, the addition of hundreds of millions of Asian workers to the global labor pool undercut the bargaining power of workers in the core of the world economy. Relocating processes in the periphery not only reduced the production costs of global firms directly but also increased their bargaining power against unions back home. The competitive pressure identified by Rogoff worked not so much through reduced monopoly pricing power but rather by forcing firms to adopt cost-competitive supply chains. In fact, it worked to increase their monopsony power in national labor markets.. Schwerhoff and Sy (2010) identify a second mechanism: competitive pressures unleashed by the ‘second unbundling’ served to eliminate the least productive firms, thereby reducing average costs, which in turn promoted disinflation.

The strongest piece of evidence against Rogoff’s mechanism is that if intensifying inter-firm competition were in fact is responsible for disinflation then the profit rates of global firms would show a marked decline as well. This is quite the opposite of what has obtained. New York Times reported last year that corporate profits were at their the highest level in 85 years. There is no sign of cut-throat inter-firm competition to be found.

Corporate profits

It is also clear why the standard textbook model fails so miserably. The central mechanism through which loose monetary policy is translated into inflation, i.e., wage inflation, does not work as advertised due to the economics of global supply chains. In the absence of wage gains, the modern ‘market-based credit system’ channels the Fed’s monetary expansion into asset markets.

A Note on Global Imbalances

In Markets on January 28, 2015 at 12:57 am

You can download a pdf version of this note here.

Abstract: This note argues that global imbalances came about as a result of the geoeconomic strategies pursued by major economic powers. Large current account surpluses of major exporting states are necessarily matched by current account deficits of large importers. The balance of payment identity ensures that we every current account entry is accompanied by a capital account entry of the opposite sign. Therefore, we may equivalently refer to countries with large current account surpluses as high-savings countries. The reemergence of a liberal international financial order converted the large savings of the major exporting powers into globally mobile capital. The resulting ‘global savings glut’ has led to unsustainable financial booms in states that liberalized their asset markets.

An equally valid story can be told that emphasizes the intensifying competition for market share between the major poles, resulting in persistent oversupply in the world’s increasingly integrated markets for tradable goods and services; and the consequent ‘secular stagnation’ in the center of the international economy. However, such a ‘current account’ narrative decouples the dynamics of global production from the ‘Minskian’ dynamic of financial booms and busts that has plagued the international economy since the reemergence of a liberal financial order. We show how sticking to the ‘capital account’ and focussing on the large savings of major economic powers brings both these dynamics closer to the center of the frame of reference. We argue that the prospects for global rebalancing are dim in light of the high-savings strategies of major economic powers.


Global imbalances in the early post-war period were characterized first and foremost by the interaction of the geoeconomic policies of three states: Germany, Japan, and the United States. The export-led, high-savings, advanced-industrial strategy followed by the two US protectorates, especially Japan, undermined the profitability of US manufacturing. The consequent stagflation crisis in the core of the world economy undermined the Keynesian consensus and led to the neoliberal counter-revolution, the centerpiece of which was the reconsitution of a liberal financial order.

Three essential steps were needed to reestablish a liberal financial order. All three were accomplished under tremendous pressure from unregulated capital flows emanating from the eurodollar market to which US capital had migrated in the fifties and sixties. First, center countries were forced to relinquish policy control over key exchange rates—the UK in 1967, Germany in 1969, and the US in 1971—thus undermining the fixed-exchange rate regime. The second step was the repeal of Regulation Q and the end of financial repression in the US; effected by a panicked Carter administration as the dollar continued to slide in 1979; later consolidated under Reagan. In the same year, Carter also appointed Volcker to the Fed with a mandate to tackle double digit inflation. Volcker sharply raised interest rates, prompting the flow of global savings to the US which sent the dollar sky-high.

Japan and Germany continued to follow an export-led, high-savings strategy. During 1945-1979, Japan had largely forced its high-savings towards increasing the productivity of domestic advanced manufacturers. With Volcker’s sky-high interest rate, strong-dollar policy after 1979, Japanese savings strained the leash of Japanese financial repression. By 1982, US Treasury officials persuaded the Japanese as well to liberalize their asset markets and pursue domestic credit expansion. Japanese savings promptly began chasing both domestic and US assets. After the American financial panic of 1987, Japan doubled down on a credit expansion at home. This yielded a super-massive asset price bubble in Japan which burst spectacularly in 1989, followed by secular economic stagnation from which Japan has yet to recover. In its aftermath, Japan switched decisively from domestic credit expansion to a strategy of exporting its high savings.

The collapse of container and jet freights in the late-sixties, and the later telecommunications revolution, set the stage for the advent of ‘globalized production.’ Japanese firms pioneered the model of unbundling supply chains, mostly to Japan’s junior partners in what became ‘factory Asia.’ These junior partners followed Japan’s export-led, high-savings strategy. During the eighties and even early nineties, countries of the Pacific rim forced their high savings and those of Japan into productivity enhancing investments at home. The nineties witnessed moves towards ending financial repression all over the Pacific rim, leading to a great asset price bubble that burst in 1997. After the Asian financial crisis, Japan’s junior partners also started exporting their savings and accumulating dollar reserves for national economic insurance.

German productivity growth had more or less kept pace with that of the US and Japan. But during the mid-nineties, Germany had directed its high savings to reabsorbing East Germany. But by the late nineties, Germany emerged as an exporter of savings; joining Japan, the newly-industrializing countries of the Pacific rim (by now including China), and the oil exporters, in exporting their savings to the US. The avalanche of savings directed at US assets bid up their prices and pushed the US tech boom into a frothy bubble, which burst spectacularly in 2000.

In the 2000s, China’s emergence as a global economic power changed the polarity of the core of the world economy from a tripolar to a quadripolar structure. China’s rise was closely tied to the ‘second unbundling’ of ‘globalized production’ whereby firms’ supply chains became extended over vast regional networks. Indeed, topological analyses of “global supply chains” reveal vastly closer ties within these three regions than without. Global production remained tripolar with one pole centered on the US but that now included Canada and Mexico; a second centered on Germany that included most of northern and western Europe; a third one, itself bipolar, in Asia centered on China-Japan that included the entire Pacific rim. Global production has continued to reblance towards the third pole at the expense of the first two. This process will likely continue well into the twenty-first century. Note that hitherto the strongest economic powers had been the most advanced manufacturing states. China has emerged as a pole of global production, and joined the top ranks in a ‘Minskian’ sense, without making deep inroads into advanced manufacturing. This is novel and remarkable. China’s sheer size has enabled it to break the mould.

The source of the bulk of the ‘global savings glut’ identified by Ben Bernanke in 2005, then, can be located in the geoeconomic strategies pursued by Japan, Germany, and China. These strategies can be seen as a strong form of ‘soft balancing’ against the United States. The glut was exacerbated by (1) the reserve accumulation strategies followed by ‘emerging markets’ and the oil exporters; (2) the relentless rise in inequality everywhere, especially the US; and (3) by the fact that US non-financial firms themselves became net suppliers of savings. How could the United States deal with the strategies pursued by the other three?

US policymakers had only three alternatives strategies available. None of them were particularly appetizing: (i) the US could give up on the liberal global financial order it had helped forge, and reintroduce financial repression; (ii) it could accept the recession effectively being exported by the other economic powers; or (iii) it could pursue credit expansion at home. Given the strong commitment to a liberal financial order among American elites, (i) was simply not on the table. The Fed’s mandate and the domestic political concerns of elected officials ruled (ii) out. The resort to (iii) was therefore inevitable. US policymakers bet on the ability of America’s deep asset markets to absorb the savings emanating from the others. The United States became the importer of capital par excellence. The asset price boom of the mid-2000s in the US and other importers of these savings was the consequence.

Global Imbalances

The implosion at the heart of global financial system in 2007-2008 did not lead to a fundamental change in the strategies pursued by major powers. China, Japan, and Germany continued their high-savings strategy. Japan and Germany have doubled down on exporting their savings. Nor did the United States change course. The Fed has resorted to extraordinary measures to shore up asset prices; looking to the attendant ‘wealth effect’ to cure the ‘balance sheet recession.’ China has redirected more of its savings towards home. It now seems to be pursing the strategy of domestic credit expansion that Japan followed in the eighties. The level of private credit in China is now approaching that of the United States. No wonder than both the US and China are now witnessing unsustainable financial booms. This has created the spectre of a third round of global financial crises that began in 2007; this time centered on China.

The root cause of the global imbalances are the high-savings strategies pursued by China, Japan, and Germany. Unless these states pursue alternate strategies to secure their economic interests there is no hope for resolving global imbalances. Note that, for the first time since 1945, we have a pole in the core of the global economy that is not a US protectorate. Alongside the emergence of other, lesser players whose combined heft is nevertheless significant, China’s rise cannot fail to make global accords more difficult to achieve. Specifically, it is hard to see how a version of the Plaza Accord of 1985 and the ‘reverse Plaza Accord’ of 1995 that served to somewhat mitigate global imbalances in the tripolar era, can be achieved now. The G20 is a significantly less effective forum for global geoeconomic bargaining that the now defunct G7. The United States could somewhat arm-twist Germany and Japan in the late twentieth century. Arm-twisting China, Japan, and Germany is going to prove considerably more difficult in the early twenty-first century.

Global imbalances will continue as long as the high-savings strategies of China, Japan, and Germany remain in place. As long as these states pursue these strategies, the ‘global savings glut’ will ensure that financial booms continue to plague the liberal financial order. Only the location of asset price bubbles will be determined by which states choose to—or are forced to—import these high savings beyond their capacity to absorb them. Given that there is little chance that these states will change their strategies, global policymakers are likely to play whack-a-mole with financial panics for some time to come.


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