The New York Times reports on the Tokyo stock exchange's early shut down. It is one of a string of trading scandals, many in Japan. It comes at a time when major market indexes are at or near post-crash peaks, and the economy, we are told, is doing just fine. In fact, we are at the edge of financial crisis, where a series of long term pressure points are going to test the economic management, not just by the US, but by the G-7 as a whole. The prognosis is not good - with a string of right wing governments grabbing power, and committed to creating more asset inflation - they are intent on pouring gasoline on the fire.
[Geekier version here.]
I'm going to try and avoid heavy econospeak, or at least translate when I need to use it. Here goes.
Business goes in cycles. Since Schumpter and Keynes, the realization has been that not only does business go in cycles, but that the cycles are good for the economy in the long run by producing the willingness to take large risks to push technology forward, and the "creative destruction" to free up resources that are better used elsewhere. Keynesian economics showed how to "manage" these cycles so that they did not produce long trough periods of very slow growth, and avoided the largest excesses of the peaks. In short, turning "Boom and Bust" into "expansion and contraction".
The business cycle has an anatomy. Short cycles have a contraction, a bottom, a recovery, a short boom, and then another contraction. Long cycles have a contraction, a bottom, a recovery, a landing, an expansion and a boom. The present economic cycle is at the point where it either gets legs to run for a long time - another 4 years - or spurts a last bit of inflationary growth, and heads back into recession.
The typical story of a business cycle centers on the "monetary authority", that is, who has the ability to determine the supply and cost of money. In most developed nations for the last 35 years, the monetary authority has been a central bank with "policy independence", or "autonomy". That is, a central bank whose policy makers are not directly answerable to someone else for the decisions they make. But the reality is that central banks don't have the power that they are often ascribed, central banks often have a choice of how things go right, or how things go wrong, rather than whether things go right or whether things go wrong. If an economy is of a mind to meltdown or blow up, the central bank more often than not can pick its poison, but not always deliver the antidote.
The official CPI is at an above comfort 3%. While this isn't an historically high rate of inflation, given the low rate of replacement of infrastructure of the US, it is high. What I mean by that is this. Think of the "time value of money", that is, a dollar today is worth more than a dollar a year from now. But this also works the other way, a dollar of happiness created a year ago, is not as important as a dollar of happiness created today. So the person who created a dollar of happiness a year ago, if he hasn't done anything else, shouldn't have as much money as the person who created a dollar of happiness today. Inflation then is the rate that we "discount", or reduce, the value of things people did before.
What this means is that the faster an economy is building up infrastructure and other things of permanent value, the faster it should be discounting the past. If it doesn't it will produce hothouses of economic activity where there is local growth, and leave the rest to its own devices. The deflationary period of the late 19th century is a good example. Go to New York in 1890, and it is recognizably a near modern city - telephone and electrical wires, mass transit, a port, paved roads, lights along major thorough fares, museums, an opera house, bridges, construction. Go to the Midwest in 1890 - and it is another world. No paved roads, no gas stations, the occasional train line, no stores except in clusters. The economy wasn't building infrastructure in 90% of America, so the past was not being discounted all that quickly. Think of it this 1ay, in 1905, it would have taken you more than a month to drive across the US, because of the lack of a road network, and you would have had to wait by the train line for spare parts when your springs blew out. Gasoline was a dollar a gallon. That's more than $20/gallon modern.
But taking into account housing inflation - which is excluded from consumer inflation calculations - the inflation rate is almost 6%, which is what you would expect from an economy that is near "full employment" - that is, an unemployment rate that is staying at or below 5% for a long period of time.
Now this has been trumpeted as a sign of a good economy, in fact, it is the business cycle's way of telling us that this particular economic cycle - the set of choices that we have made - is reaching its end point. It can't find enough of the kind of workers that it values to increase employment without raising wages. Let me unpack this a bit. During the Keynesian economy, the labor market - how hard it was to find a job - was very closely tied to the macro-economy, that is whether people were making decisions based on what they wanted to do, rather than hurrying up or slowing down based on what they thought the macro-economy would do. An economy that is "decision neutral" is one where people aren't hoarding either money or goods. It's an economy where economic actors - governments, people, companies - can send specific signals about whether the price of something is too high or too low, and those signals won't be swamped by fears of inflation, or a crash. If there are chances for business, businesses will expand, rather than keeping the money for fear of a downturn. If prices are going up, then it is because people are increasing demand.
Right now, that is where our economy is - however, instead of expanding, businesses are paying their executives and big share holders. In essence, business is saying that there isn't anything worth doing that is worth the risk. If they did, they would be raising wages, and this would be luring people into the work force. Instead, the size of the work force is going down, people are staying in school or staying home, rather than going to work.
This is the moment where, if this economic cycle has something to do, it does it. And if it doesn't inflation is generated, as people fight financially over the key assets, bidding up their price. It's going to happen eventually of course, but has it happened now? Is it happening in the next few months? The evidence is that it has.
The first is the run up of major averages around the world out of proportion to the improved prospects for world growth. The second is the bulking up of mergers and acquisitions. The time for M&A is during the shake out, big mergers at the top don't pay for themselves. Ask AT&T's former executives.
The other piece of evidence is the spread between consumer inflation, and core consumer inflation. Since 1958, recessions are preceded by a spike of consumer inflation versus the so called "core rate" of inflation. Right wing sources have argued that we should not worry about inflation because the "core" rate is low against food and energy. The reverse is the case - such spikes tend to indicate an economy that is on the verge of overheating, one that is going to require fed intervention within 12 to 24 months.
From 1958 to 2000, such a spike has corresponded with the peak of every economic cycle, heralding a fed intervention. This isn't "predictive" but instead instructive - the Fed feels inflation pressure when CPI is above the "core" or service and manufacturing, part of the economy. Think about this - it means that if materials prices are going up less than manufactured goods, we are seeing an economy that is more productive, because we are manufacturing goods and doing services that are generating more pricing power than basic food and energy. In short, it is a good sign to have core inflation higher than total inflation, and a bad sign to have core inflation below total inflation, because it shows there is more demand for goods and services, and therefore opportunities for businesses to come in.
The spike in total inflation against core inflation in 2002 was an indicator - though no one noticed it - that 2003 was going to be rotten. That is, the fed couldn't ease any more than it had, even though there was insufficient core pricing power to attract new businesses.
This last year's spike would, under normal circumstances, be a warning to the fed that it still has more inflation fighting to do - that the pricing power is with food and energy, and not in developing industrial sectors. The reason it would be a warning is that, as the 1970's showed us, commodity inflation breeds commodity inflation - it takes a long time to bring new supplies on line, and therefore economic policy has to slow the economy down until they come in, otherwise speculators pile into commodities - starving the industrial sector of the funds it needs for capital development, and convincing those with money to focus on finding ways of cashing out, not keeping their chips on the table.
However, this fed is heading us into uncharted territory, placing its faith in an untested theory of finance, that says that money will have to flow back to the US regardless, and therefore allowing the commodity winners - petro-dollar holders for example - to win will not alter the long term balance of the dollar. According to the Financial Times, it is a bet they are losing - as petro-dollars are not showing back up in the system they way they should. Instead, they are being funneled in other directions. This is why the markets have not rallied as much as they should have given the amount of investable money in the world. There is a great deal of investment demand, and it should be causing more asset inflation given how little investment supply there is.
This lack of investment supply is the key dynamic of this economy - investment supply means businesses that can throw off cash fast enough to pay for the cost of investable money. Japan has seen speculative investment, "hot money" pour into its internet sector. Other markets have seen significant run ups, without clear direction as to the use of investment, instead, massive M&A deals have been put forward, with little sign that there is any incentive not to cash out.
These signs - particularly the divergence between total and core CPI - should be taken as a warning that the current economic cycle is under threat, and that policy actions need to be taken to reduce commodity inflationary pressure, or the Federal Reserve and other Central Banks, particularly the ECB, BoJ, and BoE - European Central Bank, Bank of Japan and Bank of England - will either be forced to tighten, or not allowed to ease monetary policy in the face of shocks to the global economy. It also points to a continued incentive to move money into the commodities area - where there is pricing power - and out of goods and services, where there is not. It means that there is an incentive to invest in price reduction capacity rather than in utility producing capacity - that is to say lower prices, not better goods - which works against the core industrialized nations which rely on producing more cutting edge goods for their economies.
What bolsters this is the peaking of profits as a percentage of GDP. Generally, profits as a percentage of GDP peak at the point where inflationary pressures start to dominate the economy, in every long economic cycle, this peak has coincided with the end of easy growth. From there on in - pricing power starts to set in, as businesses try and shift some of that profit into revenue.
None of these factors say "panic", but they do say that last year was the end of the "fat years" for business profits, and that the developed core are going to be experiencing increasing pressures from inflation that haven't yet become "macro" problems, but will soon if action isn't taken. In the mean time it will mean that there will be more chances for panics to hit global stock markets, and more chances for actors such as Iran to push up resource prices by nuclear sabre rattling.
Don't you wish we had a real leader of the free world at this point? I know I do.