Capital Formation in US Firms

Brenner suggested on these pages that US capital formation has slowed drastically. Is that true? In trying to answer that question, I found the god of modern economics. More precisely, I figured a way to nail down the correct metric for capital formation and that allowed me to measure residual productivity growth; the great unexplained of modern economics. The reason why economics does not have a theory of innovation is that it falls in the social realm; in the specific sense of Matthew Crawford’s ‘ecologies of attention’. I figure that total factor productivity is a function of the vitality of situated communities of knowledge. People engaging together with the machine face incentives endogenous to the situated community centered on the machine. Firms become more productive when—as situated communities of knowledge—they learn better ways of solving their problems and increasing productivity.

Firms increase productivity in two ways: (1) deploying capital in productive assets (machinery and so on) and (2) figuring out better ways of working said assets. In order to estimate the contribution of (2) we have to nail down (1). For (2) is the residual; the portion of variation in productivity unexplained by (1). The best way to nail down (1) is to consider the net (of depreciation) stock of corporate fixed assets since firms can let capital stock erode by not replacing or repairing equipment and structures et cetera. That is, corporate investment spending may not be enough given the variation in depreciation. Instead, what we really need a handle on is capital accumulation. Figure 1 presents the raw series for growth in the net stock of fixed assets of US firms. It suggests a secular decline in US capital formation since 1966.


Figure 1. Growth in net capital stock. (Source: BEA)

The problem is that much of the variation observed in Figure 1 is an artifact of demographics. Figure 2 shows the scatter plot and series for growth in net stock of corporate fixed assets and growth in prime age population for the United States.

We must control for demographics. There are two ways to factor out the contribution of demographics. (1) Linearly project the variation of one on the other and use the OLS residuals. (2) Look instead at net capital stock per prime age adult. Happily, both yield very much the same dynamical behavior and predict labor productivity equally well. We use (2) because it admits a straightforward interpretation as capital intensity—capital stock per prime age adult. Figure 3 displays our metric for capital formation. We don’t control for real output growth or capacity utilization because of issues concerning endogeniety: Sure, capitalists are investing less because growth is slow but growth is also slow because capitalists are investing less. But assuming that demographics is exogenous is a useful fiction.


Figure 3. Growth in US capital intensity. (Source: BEA, author’s calculations.)

You can think of the graph displayed in Figure 3 in two ways: as detrended capital formation, or more precisely, as growth in capital intensity defined as the natural log of the ratio of the net stock of corporate fixed assets (chained quantity index) to prime age population. We can see that there were investment booms in the nineties, the fifties and the sixties. The two booms in the late sixties and the late nineties stand out. This observation is strengthened by the dynamical behavior of the stock of equipment and the average age of the equipment. Figure 4 shows the growth of the net stock of equipment per prime age adult. We see that average age falls in investment spurts and rises otherwise.


Figure 4. Equipment growth and ave age of equipment. (Source: BEA.)

Capital intensity and the average age of equipment are good predictors of labor productivity growth. Together they predict two-fifths of the variation in labor productivity growth. Figure 5 displays the scatter plot.


Figure 5. Capital formation and age of equipment predict labor productivity. (Source: BEA, author’s calculations.)

Figure 6 displays the 5-year moving average of labor productivity growth orthogonal to lagged growth in capital formation and average age of equipment. That is, we project labor productivity growth on lagged capital formation and change in average age of equipment, and report the OLS residuals. The origin of the Y axis has been moved to 1 for ease of interpretation. (Excel and area graphs; don’t ask.) Labor productivity orthogonal to capital formation and technological shocks (captured by age of equipment) is residual productivity attributable to gains in knowhow. The portion of growth not explained by capital formation (including the technology embedded in new equipment/machinery). It is thus a finer measure than TFP.


Figure 6. An alternate measure of total factor productivity: US labor productivity growth orthogonal to capital formation and age of equipment.

There have been two spurts in underlying productivity by our metric. A big one in the early sixties and a medium-scale one in the late-90s and early-2000s. The Sixties’ Boom stands out prominently. What explains the productivity miracle of the 1960s? That’s the big explanandum thrown up by the present study.

To gather our findings together: Looking at investment ignores depreciation. Looking at growth in net capital stock suggests a secular decline since the mid-1960s. But that is in fact an artifact of demographic shocks. Looking at the ratio of net capital stock to prime age population controls for these demographic shocks. We find two prominent investment booms in the sixties and nineties. Perhaps not coincidentally, these two periods are also times of significantly positive multi-year pure productivity shocks.


Figure 7. The balance between the three main blocs of US corporations.

The sixties were a period of unabashed hegemony of the Chandlerian firms. Manufacturing corporations accounted for more than half of all corporate profit in 1967-1969. See Figure 7. We must ask a more precise question than what’s special about the sixties. We must ask, What was going on in these Chandlerian firms that was specific to the sixties? or that was premised on conditions that prevailed only in the sixties? Did it have something to do with the passage of the reins of power to the ‘organized intelligence’ running these great corporations, pace Galbraith? seen as ‘ecologies of attention’, pace Crawford? In other words, could it be that corporate freedom from ‘shareholder value’ empowered the engineers running these corporations and allowed them to solve problems faster, thereby increasing effective knowhow? Or was it the flowering of the ‘corporate-liberal synthesis’? or maybe even the full flowering of ‘Fordism’ and ‘the Treaty of Detroit’? What the hell was going on in the sixties?


Why Did the Soviet Union Commit Suicide? Part I: Economic Stagnation

This is the first in a series of posts about the Soviet capitulation.

‘We will bury you,’ Khrushchev thundered from his UN podium in September 1960. At the time the promise seemed entirely credible. As Maddison’s data would later reveal, Soviet per capita GDP had grown at 3.3 percent in the 1950s; compared to 1.7 percent in the United States. In 1957, the Soviets had put the world’s first satellite into space and finally acquired ICBMs capable of striking American cities. Strategic parity with the United States was on the horizon. In 1956, the Hungarian uprising had been crushed and total Soviet domination of Eastern Europe assured. Communist China remained firmly in the Soviet bloc. And in 1959, the Cuban revolution had delivered a reliable ally 90 miles from the eastern seaboard of the United States.

A generation later, Soviet confidence had vanished. The Soviets had indeed achieved strategic parity; although it took a full decade. Yet, as soon as parity had been achieved Soviet economic growth ground to a halt. The stagnation made the military-fiscal burden increasingly unsustainable. Figure 1 displays the 10-year moving average of change in the natural log of Soviet per capita GDP. (So each observation captures growth in per capita income over the previous decade.)


Figure 1. Soviet per capita GDP growth. (Source: Maddison)

As you can see, Soviet economic growth fell off a cliff after 1973. In 1950-1973, Soviet per capita income had grown at a remarkable 3.29 percent per annum. In 1974-1985, the command-shadow economy clocked a measly 0.85 percent. Table 1 compares the Soviet performance in two periods with the US, West Germany, and France.

Table 1. Real per capita GDP growth
(Source: Maddison)
Soviet Union United States France West Germany
1950-1973 3.3% 2.4% 3.9% 4.9%
1974-1985 0.9% 1.8% 1.6% 2.0%

The slowdown was, of course, far from restricted to the Soviet Union. It was across the board. But nowhere was the stagnation quite so pronounced. Even at the peak of the postwar boom, the Soviet Union had lagged behind Western Europe; especially Germany. Now it even fell behind the United States. In the 12 years before Gorbachev’s ascent, Soviet income per head grew at half the pace of the United States. Figure 2 displays the performance of the four powers.


Figure 2. Per capita income growth in the Soviet Union, the United States, France and West Germany. (Source: Maddison)

Let’s briefly note the Soviet postwar achievement in absolute terms. Since we are using 1990 international dollars, we can benchmark Soviet numbers against the World Bank’s classification from 1990. In 1950, Soviet per capita income was $2,841, right above the World Bank’s Upper Middle Income threshold. In 1960, when Khrushchev made his promise, it had risen to $3,945; by 1973, it had reached $6,059; within striking distance of the High Income level. Khrushchev had essentially promised the achievement of developed country status by 1980. If we use the 1989 thresholds, the Soviets had already achieved High Income status in 1973. But it is interesting to note that, had growth continued at the pace achieved in 1950-1973 for just seven more years, Soviet per capita income in 1980 would’ve been $7,634—above the World Bank’s 1990 threshold for a High Income country in 1990. But that was not to be. Soviet growth ground to a halt. In 1985 Soviet per capita income was $6,708.

Table 2. World Bank Classification Thresholds
1989 1990 2016
Lower Middle Income $580 $610 $1,006
Upper Middle Income $2,336 $2,465 $3,956
High Income $6,000 $7,620 $12,235

I am making such a fuss about this because I want to make a number of observations about the mid-1980s conjuncture. First, the Soviet Union was not anywhere close to being a poor country. Indeed, not only was it nearly high income, since it was dramatically more egalitarian than capitalist nations at a similar per capita income level, Soviet citizens were arguably better off than those of the latter. Second, the Stalinist system of the command-shadow economy was consolidated in the 1930s and remained virtually unchanged until Gorbachev’s reforms. That system had delivered extraordinarily high growth in the 1930s, enabled the Soviets to defeat the mighty Wehrmacht, and again delivered very high rates of growth for thirty years after the war. Any notion that it was intrinsically flawed cannot stand up to this evidence. Third, the slowdown of the 1970s characterized the entire world economy. It cannot, therefore, be entirely blamed on the ossification of the Soviet system. It was most likely the result of the exhaustion of the century of unprecedented technological advance of 1870-1970, as Robert J. Gordon argued in The Rise and Fall of American Growth

Having made these points, I’m going to walk them all back a little bit. First, in order to achieve strategic parity with the United States, the Soviets devoted an extraordinarily high proportion—roughly half—of their economy to defense and capital goods. This meant that Soviet consumers were worse off than they would’ve been with a more balanced economy. Second, the Stalinist command-shadow economy may have been less capable of dealing with a major transformation in industrial affairs. As Kotkin notes in Armageddon Averted: The Soviet Collapse, 1970-2000, the problem of obsolescence of machinery and overcapacity in the “rust-belt” industries affected all industrial nations at much the same time. But while capitalist nations managed to at least partially solve it by developing new regimes of accumulation, the Stalinist factory-based welfare and production system may have been particularly unsuited to the challenge. Third, as already noted, nowhere was the stagnation quite as pronounced as in the Soviet Union.

The bottom-line is that Soviet economic stagnation was very real. Something had to be done. Perhaps something drastic. Reforms were indeed needed. But they need not have taken a form that destabilized the Soviet empire. In order to understand how the Soviet leadership lost their self-confidence we must interrogate their understanding of the malaise. In Part II, we shall see that the economic stagnation was only the backdrop of a profound spiritual crisis among the Soviet elite.


The Near-Unipolar World Reconsidered Yet Again

The rise of the continental-scale US national economy at the turn of the century made the global balance of intrinsic war-making capabilities considerably more asymmetric that it had been for centuries. As Adam Tooze describes in The Deluge: The Great War and the Remaking of Global Order, 1916-1931, Europeans recognized the transition considerably after the fact. For if Madison’s data is to be believed, the transformation of the distribution of intrinsic war potential had already been consummated at the turn of the century. The near-unipolar world can be thought of as a bag of potatoes of varying sizes the largest of which is at least twice as large as all other potatoes in the bag. That is, we use Schweller’s criteria for polar powers.

More precisely, we define the near-unipolar world as one in which one great power is at least twice as big in economic size as all other great powers. The French economy had been less half the size of the US economy since 1883; Germany fell below the 50 percent threshold in 1901; and finally, the UK went under in 1905. In 1905, the near-unipolar world was born since for the first time all European great powers’ GDP fell below the 50 percent threshold: France 30.3; Germany 46.6; UK 49.7. In the early interwar era and through the postwar era, the combined GDP of the European great powers never exceeded that of the United States. Figure 1 shows the GDP of the “Big Three in Europe” as a proportion of US GDP in constant 1990 international dollars.


Figure 1. Big Three European great powers.

According to Maddison’s data, Soviet economic size exceeded that threshold in a single year, 1938; Japan never exceeded it at all; and, at least in constant 1990 international dollars, the near-unipolar world came to an end as early as 1996 when China’s GDP in chained international dollars exceeded the 50 percent threshold. But we have more reliable market data for the latter period. In market prices, as late as 2000, China’s economy was just 12 percent of the United States’ so it is hard to get excited about what the international dollars data means. Rather, we can say that the century of American economic preeminence definitely came to an end by 2012 when China’s GDP, even at market rates, exceeded one-half America’s. So the century of American economic preeminence was 1905-2011.


Figure 2. China’s GDP exceed half the US GDP in 2012.

American economic preeminence meant that other great powers could not hope to prevail against the United States in a general war or in an extended rivalry. Once the European great powers had slaughtered each other’s young men at sufficient scale in 1914-1916, they faced a great power secure behind an impregnable moat, with tens of millions of men of military age, and a large and technically-sophisticated economy capable of fielding millions of them on the European battlefield longer than any other great power. They also faced a great power that held all the purse strings. The British got an early taste of American financial hegemony when they went hat in hand to Washington. Once the United States weighed in the balance, the war was decided.

In The Deluge: The Great War and the Remaking of Global Order, 1916-1931, Adam Tooze argued that German radicalism in the 1930s was motivated by the specter of the permanent American hegemony. In his unpublished Second Book in 1928, Hitler worried that European great powers would be reduced to the status of Sweden:

With the American Union, a new power of such dimensions has come into being as threatens to upset the whole former power and orders of rank of the States.

A continental-scale Lebensraum for the German people was necessary if Germany was to be co-equal with the United States. So unlike on the western front, in the east, Germany fought a war of extermination against the Soviet Union. The goal of Generalplan Ost was to depopulate vast swaths of land between the German border and the Urals through liquidation and expulsion. As a German military journal explained in 1935, “totalitarian warfare is nothing but a gigantic struggle of elimination whose upshot will be terrible and irrevocable in its finality.” Disorganized survivors were to be enslaved and made available to German capitalism and German homesteaders. The idea being to replicate  settler colonialism at the scale of the United States. Not until the thermonuclear revolution in the mid-1950s would American nuclear war planners develop operational plans estimated to kill upwards of 100 million people in the Soviet Union.

The Soviets were radicalized too. Through forced-pace industrialization, Stalin hoped to replicate America’s war potential. The Soviets succeeded to a considerable degree in forging a military-industrial complex of comparable scale; more so than Germany, which is why they prevailed in the Soviet-German War. An interesting question is whether the radicalism in the German military was driven more by the rising strength of the Soviet Union than the threat of permanent Anglo-American hegemony. Guderian in particular worried much much more about the Soviet Union than the United States. We shall revisit the problem posed by Russo-German relations to the near-unipolar frame at the end of the essay.

In the Venezuelan crisis of 1895, Britain backed down after Washington threatened war. At the turn of the century, the Admiralty informed the War Office that it had no plan for the defense of Canada. By 1900, once the impossibility of fighting the colossus had sunk in, the British surrendered naval primacy in the entire western hemisphere to the United States. Indeed, all three major confrontations of the twentieth century—World War I, World War II, and the Cold War—were rigged from the moment that the unipole decided to join the struggle. And postwar orders in the aftermath of each of these confrontations were dictated by the unipole.

At the Washington Naval Conference in 1922, the United States dictated the distribution of capital ships among the maritime powers. Great Britain, France, Italy and Japan realized the folly of initiating a naval arms race against the colossus and simply acquiesced. The German question, specifically, the problem of French military primacy and German insecurity revealed by French depredations in the Ruhr in 1923, was resolved by US security and market-access guarantees to Germany in exchange for German disarmament and reparations. J.P. Morgan himself saw to the details on the continent. (I’ll write more about the German question in the 1920s after I have read Trachtenberg’s doctoral thesis, French Reparation Policy, 1918-1921. For the French played a more significant role in the German question after World War I than they would do at the end of World War II or the Cold War.)

In the aftermath of World War II, postwar negotiations were ostensibly carried out in a Big Three framework between the Anglo-Saxon powers and the Soviet Union. American intransigence ensured that many important questions were left unresolved. The most important of these related to the future of Germany. It is hard to overemphasize the centrality of the German question in European history. In Europe: The Struggle for Supremacy, from 1453 to the Present, Brendan Simms went so far as to frame the entire history of the struggle for mastery in Europe around the German question; as the European great power struggle to control the heartland of Europe, Germany; until, of course, Germany was unified and the question became what to do about German power.

The Big Three had agreed to eventually resolve the German question in detail at the bargaining table. In 1944, the entire future of Germany was open for reconsideration. Was Germany to be broken up into smaller statelets? Into two, three, or four pieces? Was it to be deindustrialized and turned into an agrarian country to reduce its power as envisioned in the Morgenthau Plan? How was Germany to pay reparations? Under whose sphere of influence would specific territories lie? What about the industrial heartland of the Ruhr? Even after they had been agreed upon, were the occupation zones to be run separately by each occupying power as it wished? What was to be their socio-economic system? Were all non-fascist political parties to be tolerated in all zones? Or was a unified German state to be resurrected? And if so, was the Germany army to be reconstituted? And if German power was to be restored, was Germany going to be neutral or an ally of one of the three great powers?

Implicit in JCS1067, the official policy directive to the military government in the US occupation zone in 1945-1947, Joyce and Gabriel Kolko write in The Limits of Power: The World and United States Foreign Policy, 1945-1954, was “maximum zonal autonomy that bordered on partition” in violation of explicit US commitments at Yalta. Of “substantially greater consideration in American planning,” was “the value of Germany as a barrier to Soviet power.” America planners had secretly arrived at a consensus on what was to be done with Germany. German power was to be resurrected and incorporated into a US-led military alliance. Moreover, German recovery was essential to hold the tide against the Left in Europe so there could be no question of serious reparations. Remarkably, despite explicit commitments to the contrary and despite the fact that the Soviets had defeated Germany, the United States unilaterally obtained its preferred outcome on the German question. Why?

The problem with the near-unipolar frame is that America’s economic preeminence suggests the wrong answer. For the balance of strategic power became a question of forces-in-being after the Strategic Air Command became a war-winning first-strike weapon. Even in the late-1940s, the Soviet Union was exhausted and in no position to threaten general war. The introduction of a single currency into the three Western zones—a recipe for a West German state that contained 75 percent of German war potential—led to the Berlin Crisis of 1948. The United States prevailed by threatening general war. The Berlin crises of 1948 and 1958-1961 were not about West Berlin, they were about the German question. Indeed, as we shall see, the German question may be the key to the 20th-century as a whole.

At the end of the 1950s, at a time when Soviet ICBMs began to threaten the US homeland for the first time, at issue was the introduction of tactical nuclear weapons into Germany. The United States prevailed by threatening a thermonuclear first-strike. Kennedy and his advisors at the RAND corporation had believed that the Soviets would soon field 200 ICBMs. At Vienna, he conceded to Khrushchev that the Soviets had achieved strategic parity. But spy satellite images revealed a few months later that the Soviets only had 4 operational ICBMs. The Soviet Union had never acquired a bomber command capable of penetrating US air-defense. Soviet nuclear strength was mostly regional. They had a thousand short and medium range nuclear missiles that threatened Western Europe. But they could all be taken out in a massive counter-force strike by the unipole.

A purely counterforce attack on all Soviet strategic nuclear forces would kill perhaps 60 million. A countervalue first-strike made little sense; as McNamara explained, the enemy’s cities are our hostages. But SIOP 62, the only US operational plan available to Kennedy insiders, had been perfected by General LeMay’s SAC over the 1950s. It was both counterforce and countervalue; targets had by now proliferated enough to guarantee the obliteration of Soviet urban civilization. In fact, it threw in China for good measure. SIOP 62 called for a massive preemptive strike on the Sino-Soviet bloc that would immediately kill 600 million people and turn both nations into “smoking, radioactive ruins.”

It was later discovered by climate researchers in the 1980s that the detonation of enough thermonuclear warheads to yield 3,000 megatons, as planned in SIOP 62, would very likely precipitate a nuclear winter. Temperatures would drop 30-40 degrees at all the globe’s major food producing regions with the result that almost no grains would grow on the planet for many years. The resulting famine would kill off the vast bulk of the world’s human population in a global holocaust. Human civilization for all practical purposes would end in a spectacular orgy of hunger, chaos and cannibalism.

As Shelling has observed, thermonuclear weapons had turned geopolitical competition into a competition in risk-taking. Instead of military skirmishes that now posed an intolerable risk of general war, great power confrontations turned into diplomatic crises. The major nuclear crises of the Cold War occurred before the Soviets achieved a second-strike capability in the mid-1960s. Put another way, the unipole had a splendid first-strike capability for the first 20 years of the so-called bipolar era. In each of these crises the United States brought its nuclear superiority to bear. Once Kennedy had called Khrushchev’s bluff, the latter simply abandoned Soviet hopes on the German question for the time being. The erection of the Berlin Wall signaled that the Soviets had acquiesced to both the partition of Germany and the introduction of tactical nuclear weapons into the Bundeswehr.

Kennedy may have inadvertently threatened omnicide, but what mattered was that both Khrushchev and Kennedy believed the first-strike threat. While Kennedy mobilized his strategic forces and put Nato forces on high alert, Khrushchev, General Burnical recalled, “never alerted a bomber or changed his own military posture one bit. We had a gun at his head and he didn’t move a muscle.” (Quoted in Trachtenberg, “The Cuban Missile Crisis.”) Nitze talked about the experience in Foreign Affairs in 1976:

…the feared intercontinental ballistic missile (ICBM) “gap” of the 1960 presidential campaign never in fact became reality, but on the contrary the United States re-established a clearly superior nuclear capability by 1961-62. This was the situation at the time of the only true nuclear confrontation of the postwar period, the Cuban missile crisis of the fall of 1962.

[This is] the reading the Soviet leaders gave to the Cuban missile crisis and, to a lesser extent, the Berlin crisis. In the latter case, Khrushchev had briefly sought to exploit the first Soviet rocket firings of 1957—by a series of threats to Berlin beginning in late 1958—but then found that the West stood firm and that the United States quickly moved to reestablish its strategic superiority beyond doubt. And in the Cuban missile case, the very introduction of the missiles into Cuba in the fall of 1962 must have reflected a desire to redress the balance by quick and drastic action, while the actual outcome of the crisis seemed to the Soviet leaders to spell out that nuclear superiority in a crunch would be an important factor in determining who prevailed.

Harking back to the Soviet penchant for actually visualizing what would happen in the event of nuclear war, it seems highly likely that the Soviet leaders, in those hectic October days of 1962, did something that U.S. leaders, as I know from my participation, did only in more general terms-that is, ask their military just how a nuclear exchange would come out. They must have been told that the United States would be able to achieve what they construed as victory, that the U.S. nuclear posture was such as to be able to destroy a major portion of Soviet striking power and still itself survive in a greatly superior condition for further strikes if needed. And they must have concluded that such a superior capability provided a unique and vital tool for pressure in a confrontation situation.

Trachtenberg notes that the Berlin crisis of 1948 was the result of Soviet opposition to the reconstitution of a German state that would be allied to the West; the Berlin crisis of 1958-1961 was the result of Soviet opposition to the introduction of tactical nuclear missiles into the Bundeswehr; but there was dog that did not bark. The reconstitution of the German army and its incorporation into the Western military alliance in the early-1950s did not lead to Soviet ultimatums. Instead Stalin issued the 10 March 1952 Note with its offer of German unification on largely Western terms. Paul R. Willging’s superb doctoral dissertation “Soviet Foreign Policy in the German Question: 1950-1955,” made a compelling argument that the Soviets were indeed willing to accept any and all terms as long as the unified German state would be neutral. Why?

By 1952, the Strategic Air Command had became a war-winning first-strike weapon. The United States’ air-atomic monopoly was no longer just one factor in the balance of global power. It had become the factor. What Eisenhower’s “massive retaliation” doctrine meant in operational terms were war plans drawn by the SAC for a massive preemptive first-strike. Incontestable US nuclear superiority was the context of Stalin’s conciliatory offers.  In general, the postwar German question was settled on favorable terms above all because of US nuclear superiority.

We have seen that the revolution in strategic affairs wrought by nuclear weapons meant that forces-in-being that could be expended on the first day or month of a general war instead of the economic-industrial capability to fight a long, drawn-out war of attrition was what really came to matter in great power confrontations. This calls into question the validity of the near-unipolar frame that we defined above in terms of economic preeminence. But there is yet another reason to be skeptical of the near-unipolar frame.

As Wohlforth explains in The Elusive Balance: Power and Perceptions During the Cold War, the Soviet empire did not simply collapse in the late-1980s; instead, the Soviet leadership capitulated with eyes wide open. What Gorbachev and his advisors were really after was the dream of a greater Rapallo—the Soviet-German treaty of 1922 that fostered military and economic cooperation between the two powers. Third World clients were abandoned outright; Eastern European satellites were let go one by one in 1989; even the “crazy arms race” with America was given up in the hope of reducing tensions with the West. Their only demand was to be welcomed by Germany into Europe. They hoped that with genuine friendship and close ties between the Soviet Union and a unified Germany, the United States could be sidelined. The German question was the only question that the Soviets truly cared about.

The central importance of the German question, of Russo-German relations in geopolitical history, and of forces-in-being in the global balance of strategic power as it came to weigh on international politics suggests that the near-unipolar frame must be thought of as a point of departure instead of the point of arrival.


Cross-Border Banking Flows as a Metric for the Global Financial Cycle

Perhaps Nomi Prins did not choose the title of her piece “The next financial crisis will be worse than the last.” But the idea that there is going to be another financial crisis in the center of the world economy in the near term even vaguely comparable in virulence to the GFC has, as we shall see, no basis in reality. The reason is straightforward. Financial crises are denouements of credit booms, not asset price booms—all credit booms are attended by asset price booms but not the other way around—and while there is certainly an asset price boom in global markets, there is no credit boom at the center of the world economy. The chances of a banking crisis are even more remote than credit indicators suggest because of the extraordinary surveillance of the balance sheets of global banks since the GFC. Even if all legal-regulatory innovations over the past decade—especially the tighter limits on capital ratios—are bull, the sheer fact of enhanced regulatory and independent balance sheet surveillance means that banks find it much more difficult to hide risks on and off their balance sheets.

We now have a good handle on the mechanics of financial booms and crises. Financial booms are banking expansions. Banks are special because, yes, they create money by lending. But do not let the Bank of England distract you. The issue is that the excess elasticity of bank balance sheets mechanically generates lending booms since bank assets are the liabilities of non-banks. As a rule, credit booms emerge from the mutually-reinforcing interaction of property prices and bank lending. As collateral values go up, more can be lent against the same property; in turn, greater lending pushes up property prices further. Credit booms show up in credit gap measures such as credit-to-GDP ratios. We also understand how credit booms end. The stock of outstanding debt lags behind credit gaps. Once the debt burden, which is a function of the stock of outstanding debt not credit growth, becomes intolerable, credit defaults puncture the boom and precipitate a financial crisis. That’s why the best predictors of financial crises are credit gaps and debt ratios.

Metropolitan banking is international. As the day progresses, the trading book of global banks passes from Hong Kong to London to New York. The transatlantic circuit is especially important. The mid-2000s financial boom was driven in large part by a transatlantic, European banking glut. In other words, there is good reason to believe that cross-border banking flows are a especially good barometer of the global financial cycle. I therefore decided to analyze the JEDH database on cross-border banking and debt flows.

I’ll probably have much more to report later. But here’s the basic picture. Figure 1 displays three variables; all standardized to have mean 0 and variance 1. “CoreFPC” is the first principal component of the cross-border flows of Japan, Germany, France, Italy, Netherlands, Norway, Sweden, Denmark, and Finland. Roughly speaking, it captures the common variation in the series. “G2” is the sum of the cross-border flows of the United Kingdom and the United States. “China” is the sum of the cross-border flows of China, Hong Kong, and Macau.


Figure 1. Cross-border banking flows.

A few observations are in order. The tight coupling of Anglo-Saxon finance (“G2”) and the rest of the core (“coreFPC”) is manifest; thus allowing us to interpret either as providing a fair metric for the global financial cycle. We will use the former because (a) it is a tighter, more parsimonious definition; (b) it is applicable in more general settings in the sense that we can extend many macrofinancial variables back to the 19th century without changing our center countries. Hélène Rey’s notion of the global financial cycle—as the covariation of risk premia embedded in global asset prices—is less relevant to macrofinancial stability than our metric. Although banking expansions can be read off of asset prices, it is a noisier metric precisely because not all asset price booms are attended by real financial booms that end in tears. Cross-border banking flows provide a finer measure of banking gluts than the compression of risk premia because all lending booms are attended by cross-border banking flows and vice-versa.

This metric confirms what credit gaps and debt service ratios can tell us about the buildup of financial imbalances in the center of the world economy. Interestingly, by this metric the Chinese cycle seems to have turned. This was not clear when we looked the credit gap (Figure 2).


Figure 2. China’s macrofinancial vitals.

Finally, as a sanity check we look at the bond market. The slope of the yield curve is the best predictor of US recessions out there. When the yield curve inverts it heralds a recession in the near term. There is good reason for this. The inversion of the yield curve destroys banks’ net interest margins; forward-looking measures of banks’ net worth fall; banks respond by shedding assets; finally, the attendant fall in bank lending pushes the macroeconomy into recession—this is Adrian and Shin‘s risk-taking channel of monetary policy. The term spread has indeed compressed, but the yield curve is still upward-sloping.


Figure 3. The term spread.

Because the current asset price boom is unattended by a credit boom in the center of the world economy, the possibility of a financial crisis comparable to the GFC is remote. And despite the “age” of the expansion, a normal recession does not yet seem to be on the cards either.





The President and the Stock Market

Authers’ Note today sounded downright exasperated with the President’s tweets. Trump claimed credit for the fastest 1,000 point gain in the Dow’s history:


That’s too cute by half. Each 1000 percent gain gets mathematically smaller as the Dow goes up; eg, the move from 10,000 to 11,000 is a 10 percent move whereas that from 24,000 to 25,000 is just 4 percent. Properly compared, the performance of the Dow under Trump lies between equivalent periods in Obama’s two terms.

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But the Dow is a stupid aggregate of stocks for the simple reason that it is price-weighted. “Over the past year,” Auther notes, “two great industrial giants have been the alpha and omega of the Dow: Boeing has doubled, gaining $85bn in market cap, while GE has collapsed by more than 40 per cent, shedding a staggering $118bn. But due to the ridiculous way in which the Dow is calculated, Boeing accounts for a rise in the Dow of 1,064 points, while GE accounts for a fall of only 84 points.” That’s because Boeing has 600 million shares outstanding valued at $309 each for total market cap of $184 billion; while GE has 8.7 billion shares worth just $18.5 each for a total of $161 billion. The differential sensitivity of the index is an artifact of the practically irrelevant question of how many shares the firms have outstanding.

If we ignore the Dow and look, as all serious investors and analysts do, at the S&P500, even Obama’s 1st year in office comes out ahead of Trump’s.

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In a more longer term perspective, the Trump rally hardly stands out either.

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More generally, Presidents have little influence over the stock market; central banks much more so. But we should not even exaggerate the influence of the latter. Stock valuations are sky-high not just because of monetary accommodation but mostly because the near-term global macroeconomic outlook is especially positive for risk assets. Not only is global growth more robust than it has been in a decade; there is little sign of inflation, which implies that there is little incentive for central banks to take away the punch bowl any time soon. It is this benign macro environment that is compressing market-wide risk premia.

Investors are facing two main risks in the near term. The first is that growth may falter and cash flow expectations may need to be marked down, with attendant corrections in asset valuations. In the extreme, the economy may even plunge into a recession; although that scenario seems unlikely in the near term—the yield curve may be shallower than before but it is still sloping upwards. The second is that inflation might finally show up, forcing the Fed to hike much faster than anticipated, thereby precipitating a risk-off. In other words, markets have been in a sort of Goldilocks Zone. Either a significant deceleration in global growth or a significant acceleration that eliminates global slack can precipitate a sell-off.

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Source: US Treasury.


Does Consumer Confidence Predict Output Growth?

Tip of the hat to Ted Fertik for flagging Mian, Sufi and Khoshkhou (2017). The authors examine the role that partisan bias plays in consumer expectations. One of their findings is that consumer confidence is extraordinarily high among Trump supporters. But that this has not translated so far into higher spending.

I was skeptical of the notion that consumer confidence—as opposed to CEO confidence, investor confidence, and the risk appetite of intermediaries—had discernible and predictable effects on real economic activity. So I examined the data. Turns out that it does. And that it does so through a clear channel: Consumer confidence predicts discretionary consumer spending which in turn is a strong correlate of real GDP (RGDP) growth.

The evidence can be read off Figure 1. Read clockwise from top-left. (1) University of Michigan’s Index of Consumer Sentiment (MCSI) predicts RGDP growth even after controlling for lagged RGDP. (2) MCSI predicts growth in real discretionary consumer spending. (3) MCSI does not predict RGDP growth shocks orthogonal to discretionary consumer spending. That is, the residuals obtained by projecting change in log RGDP onto change in log consumer spending are not correlated with lagged consumer spending. (4) Discretionary consumer spending is contemporaneously correlated with growth in RGDP.


Figure 1. The empirical evidence for the confidence channel. The data is at the quarterly frequency and for the period 1960Q1-2017Q3. Source: Haver Analytics.


Was the Great Recession a Natural Calamity?

Tip of the hat to Adam Tooze for flagging Annie Lowry’s excellent round-up of the Great Recession’s impact on American society. After ‘the economy tipped into the deepest contraction of the post–World War II era’, Lowry writes, ‘the Great Recession’s scars remain’. The recession exacerbated troubling movements already underway: erosion of middle-skilled jobs, vertical polarization of the labor market, decline in labor market participation, economic insecurity, racial polarization, vertical polarization, regional polarization, and the opioid crisis. ‘A sicker, more unequal, more racially divided country: This is the legacy of the Great Recession.’ Her conclusions are worth quoting in full and bring the framing into sharp relief.

When the next recession comes the data on what to do about it will be there. Economists have pulled together plenty of studies of the dollar-for-dollar effectiveness of initiatives like extending unemployment insurance and increasing the size of the food-stamp programs, and the relative ineffectiveness of things like corporate tax cuts. Social scientists, social workers, and local officials have urged the importance of acting as quickly as possible to intervene, with efforts to stabilize financial markets, increase the deficit, and make monetary policy more accommodative. The country has now gone through three consecutive jobless recoveries, with downturns tending to amplify long-existing trend to hollow out the middle class, polarize the labor market, and hit already ailing regions hard. It seems likely that the next recession will do much the same.

The question is whether policymakers will take such evidence of the pain and scars left by the Great Recession into account. Congress is today on the verge of pushing forward a tax cut aimed at rich families and profitable corporations that will add more than a trillion dollars to the debt, with no real need for new economic stimulus at the moment. Meanwhile, it has declined to do much for the poorer families that are still feeling the worst effects of the last recession and have not yet recovered. The risk is that next time, they will get left even further behind.

In short, recessions are naturally-occurring calamities like hurricanes or earthquakes. The policy questions they raise are about the effectiveness of various measures to deal with them. Macroeconomic studies provide insights into the shock; microeconomic studies allow us to explore the impact of the shock on different markets and social groups. We have learned a lot since 2008 and these acquired knowledges should be brought to bear ‘the next time’. A rational policy framework must incorporate all these insights to fight the next one. This is not Lowry’s personal frame of reference. This is the dominant frame used by economists and laypeople to think about the Great Recession.

All frames are necessarily partial; they illuminate some aspects of reality and leave others in the dark. The recessions as natural calamities frame is especially problematic. For the scale and virulence of the Great Recession was not the result of a random draw; nor was it independent of economic policies pursued. The scale and virulence of the Great Recession was due above all to the unprecedented amplitude of the financial cycle. The recessions as natural calamities frame leaves out the most important policy lesson to be learned from the catastrophe: financial booms are extremely dangerous and must be tamped down vigorously. The principal policy failure did not occur in 2009-2010; it occurred in 2004-2006. Policymakers and regulators failed to appreciate the build-up of great financial imbalances. And that failure led directly to the catastrophe of the Great Recession.

US financial cycle

Source: Claudio Borio.