When risky zero-sum behaviours prop-up growth
In an extended research note out this month entitled Bubble or Nothing, David Levy of the Jerome Levy Forecasting Centre sets out to prove that the modern investment tendency of putting balance sheet growth above all else has added untold risk to the global economy. And we don’t really appreciate quite how so.
The point really is that the sort of public attitudes that made WeWork’s valuation seem reasonable in the first place, are finely distributed across the entire economy, inflating balance sheets at all levels everywhere.
Channelling Larry Summers’ previous observation that the global economy seems to be fuelling itself on bubbles, Levy warns the so-called “Big Balance Sheet Economy” must keep swelling private balance sheets relative to income to keep powering itself along, only making the distortions worse as it goes. The implication being -- to cite an Adam Curtis turn of phrase -- there’s been a hypernormalisation of bullshit as a business model to the point that nobody can recognise it’s bullshit at all.
This game, however, must inevitably come to an end.
From Levy:
There is, at some point, a limit to how disproportionally large U.S. private balance sheets can become, and balance sheet ratios may already be in an extended topping process.
He adds (our emphasis):
Since the mid-1980s, the U.S. economy has been swept up in a series of increasingly balance-sheet-dominated cycles, each cycle involving to some degree reckless borrowing and asset speculation leading to financial crisis, deflationary pressures, and prolonged economic weakness. Each troubled episode has compelled government to engineer dramatic new lows in interest rates, aggressive fiscal stimulus, and other stabilization measures. Each time, these influences have established at least a sluggish economic recovery but also planted the seeds of the next round of rapid balance sheet expansion. In the Big Balance Sheet Economy, ending a recession and crisis has meant halting or at least moderating balance sheet contraction, and establishing a new economic expansion has required brisk balance sheet expansion.
Thus, each cycle has led to new balance sheet excesses with inflating asset bubbles playing major roles in generating profits. The 2000s housing bubble, or something like it, was bound to happen. Had there not been the mania in the housing market, the mortgage-backed asset boom, and all the risky and sometimes reckless, foolish, or dishonest behavior that accompanied them, then some other set of highly speculative, excessively risky, and destabilizing behaviors would have been virtually inevitable.
Thanks to the tyrannical mathematics of the Big Balance Sheet Economy, people could not meet their financial goals, obligations, and expectations through financially sound behavior, and the option of settling for much less was too painful for many. They therefore rationalized behavior that gave birth to a bubble, and the inflating bubble drew in more participants and encouraged even more reckless behavior. The same can be said of the 1990s tech bubble and other major bubbles from the 1980s onward.
If you’re thinking, well, that’s dandy but we learnt about these sorts of risks in 2008 and have taken significant regulatory steps since then to manage the risks accordingly, Levy argues that doesn’t matter. The big balance-sheet force is stronger and temporal stability -- in line with Hyman Minsky’s thinking -- is mostly a red herring. Tough balance-sheet reducing choices will have to be made eventually. And that doesn’t just mean significantly cutting the valuation of an occasional overhyped stock.
At FT Alphaville we’ve been calling the phenomenon TEEIFF (the entire economy is Fyre Festival). But Levy’s point is actually more profound.
His concern is that our shared common interest in maintaining the delusion that what we’re doing is adding value, because if we don’t we all lose out, only leads to growing pressure for financial decision makers to take on even more risk. And thus more investment in activities that offer limited income potential relative to balance sheet growth.
An indication something is really going wrong comes in the secular decline in US capacity utilisation:
As Levy notes, a chronically low capacity utilisation measure can be evidence of past over-investment in fixed capital, implying widespread and recurring shortfalls of production relative to firms’ expectations. High office vacancies -- something the US is also experiencing -- also imply a secular rise in unused capacity.
And while it might be tempting to explain that away with globalisation and the transfer of productivity to areas like China, it’s worth noting China is not immune to its own big balance-sheet problem.
Another extract (our emphasis):
Rising balance sheet ratios were a speeding train that promised a death sentence in the form of subpar returns. If people and organizations had rigidly stuck to their established financial practices, the careers or financial well-being of many household, business, and financial sector decision makers would have been damaged or destroyed. Thus, psychology, sociology, culture, regulation, demographics, technology, and other influences may all have played significant roles in shifting attitudes about financial behavior, but the driving force, at least in the era of the Big Balance Sheet Economy, was the set of macrofinancial changes caused by rising balance-sheet-to-income ratios.
Moreover, as people responded to the new financial pressures, they caused still more balance sheet expansion as they increasingly speculated on asset prices and made or took out risky loans. Thus, risky decisions in each business cycle contributed to balance sheet growth, which increased the pressures for excessive risk taking in the next business cycle—and the process is still in effect.
The problem for us, warns Levy, is that there is no nice solution to the big balance sheet economy dilemma. It either pops painfully or deflates slightly less painfully.
One thing that is worth bearing in mind, however, is that if Levy is right, the current fad for “capitalism with purpose” (a move that might only reduce incomes relative to the size of balance sheets) could conceivably bring us closer to the pop, in so doing delivering capitalism with pain as well as purpose.