The economy this fall

TL;DR – Things I’m worried/not worried about:

  • Not worried – recession, there’s no sign of one on the horizon
  • Worried – stock market correction, stocks are overvalued, there’s lots of bad news, I sense a correction in the offing
  • Not worried – inflation.  Most of the “Inflation!!!” in headlines is due to supply/demand imbalances, which should go away in the next 1-3 years.

Not worried: Recession

First, the good news.   Inverted yield curves are a powerful signal of an incoming recession.   The last time there was an inversion was in 2019, right before the pandemic recession.  Thankfully, the yield curves on US Treasury bonds (which often invert 6-12 months before recessions) are all normal and aren’t showing any sign of a recession on the horizon.  Which suggests that any near-term market tumult is likely to be temporary.

My only hesitancy here would be the rumblings I’m hearing about the Chinese real estate bubble.   Keep an eye on that.   If I’m wrong about “no recession”, that’s the most likely reason why.

Worried:  Stock Market Correction

That said, there is a lot of reason to suspect a stock market correction of 10-20% is looming in the near future.    Let’s consider a few issues at hand:

  • COVID Delta’s spread appears to be slowing 3rd quarter GDP growth.
  • Less than 1/3 of the expected job openings were filled in August, likely due to COVID concerns.
  • The Fed is poised to “taper” its support of bond markets in the near future.
  • Federal pandemic protections (unemployment + eviction halts) has effectively ended.
  • There are growing rumblings of a financial bubble in Chinese real estate.
  • The GOP is threatening to weaponize the debt ceiling again.

And yet despite all that potential terrible news, the stock market keeps climbing.   That dichotomy cannot continue forever.   I’d be shocked if it lasted until November.  The stock market appears to be running on “irrational exuberance” and primed for a correction.

I’ve created a chart using five standard ways of measuring stock market valuation.   Even though they use different measures, they all approximately similar results.   And they show that the current stock market is the second most overvalued its been in the last 140 years, surpassed by only the Dot.Com bubble.    Which suggests that when the market turns pessimistic, it is likely to have a larger-than-usual correction.

The bottom valuation indicator (AIEA) shows the best correlation with subsequent 10 year S&P 500 yields.    At its current valuation, the S&P can be expected to have negative returns over the next decade.

But stocks aren’t the only overvalued asset.   Housing (2nd graph) and gold (bottom) are also highly overvalued by historical measures.    So are bonds and cryptocurrency (side-note: never invest in cryptocurrency…)

So right now I’m in cash for the next few months until a “buying opportunity” emerges in the stock market.    Then…   If the prices are good, I like the long-term above-average  growth shown by Tractor Supply, Dollar General, U-Haul.   Still researching others, so if you have a good suggestions, let me know!

Not worried: Inflation

Prices have risen in recent months due to two potential factors:  Inflation or inflation expectations, and supply/demand imbalances.   We know the latter is a major factor (new used cars, lumber, CPU’s and other electronics have all experienced substantial price increases due to demand exceeding supply.

So how do you tell “supply/demand” price increases from actual inflation?   I personally prefer to look at Consumer Price Index inflation (which is more subject to buffeting by supply/demand) vs 10-year breakeven inflation (which IMO is a better gauge of actual inflation, since bonds are low-margin and bond traders can’t afford to be wrong).

CPI Inflation is much more volatile than 10-year breakeven inflation.  There’s always a bad harvest, manufacturing plant fire, run on toilet paper, or something that temporarily makes things a bit more expensive.   And we *know* there are huge supply/demand imbalances that are having huge effects on prices right now.

But supply/demand imbalances cut both ways.   The next harvest is fine, they rebuild the plant, they catch up on toilet paper, they get computer chips to build their cars, and the price falls back down.   Indeed, they often end in a supply glut where prices (and profits) fall below their normal levels.

Supply/demand imbalances can temporarily allow manufacturers to reap outsize profits.  But competition will erode excess profits from supply/demand imbalances (assuming no sneaky collaboration between competitors to prop up prices, which sometimes happens).  But competition cannot erode inflation.

When “inflation” shows up in CPI inflation but not Treasury breakeven inflation, that strongly suggests that it’s not actual inflation.   If you look at breakeven inflation, it’s the highest it’s been in a few years, but it’s back at the level it was in 2012, and I don’t remember people clutching their worry beads about inflation then.

The two big possible exceptions are labor prices and home prices as both of them have historically proven “sticky”.   I don’t worry about higher labor prices too much as I think people with more money in their pockets to spend is a net good for the economy.    I don’t think home prices are likely to plunge  ala 2008 anytime soon, but I suspect the Fed’s imminent taper is likely to pull the plug on the extraordinary growth rate we’ve seen over the last few years.   If you’re going to sell your home, right now is probably a very good time…

If you’re asking why you’ve heard so much about  “Inflation!!!” this year, there has been a huge incentive for the Biden administration to push the “Inflation!!!” angle has hard as possible, regardless of its verity.   When people smell inflation and believe things will be much more expensive tomorrow, they tend to pull ahead their future purchases to today.  That additional purchasing stimulates the economy.   It’s like a free fiscal stimulus, all they have to do is not say anything that contradicts the story.

Just because I don’t think we have “Inflation!!!” now doesn’t mean I’m not concerned about it.   I definitely expect that inflation will be higher than average over the next decade.   I just believe that deflation is the bigger near-term risk.

The “Biden Boom” is not a natural, healthy business cycle, but was paid for by a lot of money printing at the Fed combined with a tremendous amount of fiscal stimulus by Congress.    If the ER doctor gives your near-death grandfather a shot of adrenaline to the heart, grandpa might be able to run circles around the hospital, but don’t mistake motion for health.    Our economy isn’t healthy at all, merely running on economic adrenaline.  And I expect grandpa is more likely to crash and burn than win a slot on the Olympic team.

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Just Another Manic Monday…

There appear to be two schools of wildly-diverging thought among investors right now, and I’ve been thinking how to bridge the two camps, since I can’t imagine them being both so incredibly wrong given the trillions of dollars on the line on each side.

On the pessimists side are numerous successful investors (Ray DalioJeremy GranthamCharlie MungerMichael Burry) who believe the economy is in a massive bubble.  Both the Buffett Indicator and Shiller PE show the stock market is highly overvalued by historical measures.   Shiller PE in particular shows the stock market as being the 2nd most overvalued in the last 140 years.

On the optimists side is the bond market, where the yield curve is normal and not inverted, and showing signs of increasing but modest inflation.   Which is a sign of a recovering economy.   Rising inflation expectations is telling us that our big problem right now is that the economy is recovering *too* quickly, which is a nice problem to have.

The stock market is likewise showing optimism about the near-term.    VIX is a measure of how much volatility markets foresee in the near future.    When the SP500 is hitting new heights, but the stock market is concerned about an imminent crash, VIX will rise.   When SP500 hits a new heights but VIX is falling, that indicates confidence that a crash is not imminent.   The falling VIX shows the market is increasingly growing confident about the stock market’s near-term future.


With the Fed’s foot firmly on the gas pedal, a massive fiscal stimulus working its way through Congress, and with a de facto second fiscal stimulus in the form of a major infrastructure bill in view, the odds of a recession related to the business-cycle or Fed overtightening this year is basically zero, though some shock like war or natural disaster could still come out of left field.

But we’ve seen instances where the stock market crashed even when the real economy kept growing.  The best example is the “Black Monday” crash of October 19, 1987.   The stock market had risen 44% year-to-date in 1987, and gotten significantly ahead of the underlying economy.   The resulting stock crash on Black Monday hit like a bolt from the blue, for reasons that are still not well-understood.  The S&P 500 dropped 20% in a day, but the real underlying economy (as measured by GDP) kept right on growing.

A scenario similar to a “Black Monday” could easily play out this year.    The stock market has gotten significantly ahead of the underlying economy due to fiscal stimulus, optimism about the pandemic ending, inflation expectations, etc.   The stock market, or at least the most overvalued sectors of it, could experience a significant correction (alongside other overvalued assets like cryptocurrency) out of the blue and wipe out a lot of paper wealth, while the underlying economy keeps on strengthening.

That’s a plausible scenario, but of course doesn’t mean it must happen.    The stock market could keep plowing upwards on sheer momentum regardless of nosebleed valuations.   But it’s a possibility to keep in mind when making investment decisions.   In recent weeks I’ve watched friends on Facebook plowing money into tech stocks and cryptocurrency, not understand that at their current valuations they aren’t an investment, merely a lottery ticket with a substantial chance of leaving them poorer.   If you pay $10 for a $5 bill with the hopes that you can find someone to buy it for $20 tomorrow….   That will eventually fail spectacularly.

The current bubble will eventually run out of steam and pop.   I suspect that, whenever the end of this bubble arrives, it will do so with relatively little advanced notice by historical standards.    Given how artificial and manipulated the current economy is,  I don’t suspect it will “coast” for several years like it did during Obama’s last term/Trump’s first term, but is more likely to experience a Wile E. Coyote moment of running off the cliff, briefly peering down, and then falling precipitously.

Hopefully that’s a blog post for another year.

Disclaimer:   I’m currently invested in BRK.B, DODGX, FSLBX and cash equivalents.

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Contigion: Cheatham County edition

Unfortunately, it looks like the COVID-19 virus plaguing China is here to stay, and my assumption is that it will eventually make its way here to the US.   So I wanted to go over some basic info on the virus. I will be updating this page going forward as long as it makes sense to do so.

  • When can we expect a vaccine/cure?

It is expected to take 18-24 months to generate enough vaccinations to inoculate the general public. Though that depends on a) the vaccine passing clinical trials without encountering major problems and b) if a vaccine *can* be created.   We’ve been trying to develop an AIDS vaccine for 3 decades, as well as vaccines for several other viruses without success.   So a vaccine is not a given, and even if we can make one, it might conceivably take years/decades.

And while scientists are testing various drugs on patients to see if any are effective, they haven’t announced any “silver bullets” yet (though there are a few including chloroquine, an antimalarial drug, that are showing good results in initial testing).

So for the foreseeable future, public health measures are our best and likely *only* way of stopping the spread of the virus.

  • What is the fatality rate of the virus?

The virus appears to hit three groups especially hard: a) Older people, b) men, and c) smokers and former smokers. Obviously, the more of those risk factors you have, the more susceptible you are going to be to it.

Click here for the Johns Hopkins dashboard on the virus.   The numbers on this page will be used for the formulas below.

There are two ways of calculating the fatality rate: dividing deaths by confirmed cases (which tends to *underestimate* the mortality rate), and deaths / (deaths + recovered), which tends to *overestimate* it).

The Chinese government and WHO have been using the first measure.

Fatality Rate = deaths / confirmed cases = 2,466 / 78,891 = 3.1%

However, this measure is flawed in several ways. The most important is that many people who are confirmed to have the virus are fairly new, and thus haven’t had time to become seriously ill. If someone has had the virus for a week, you can’t really say they’ve survived until several weeks later, as many patients have relapsed or died suddenly weeks after their initial infection.

By the other measure:

Fatality Rate = deaths / (deaths + recovered) = 2,466 / (2,466 + 23,386) = 9.5%.

Which is significantly higher. This number tends to *overestimate* the fatality rate because a) the Chinese appear to be especially susceptible to the virus due to their extreme pollution weakening their lungs, b) it can’t count cases where the person is infected but doesn’t get sick, and c) we are likely to get better at fighting the disease as time passes.

By comparison, the seasonal flu has a 0.1% mortality rate.  So by conservatives estimates this virus is between 31 and 95 times more deadly than the seasonal flu.   And while I hope further data sharply decrease this number, this is where we are right now.

This is *not* a virus you want to take chances with.

  • What is the transmission rate?

The official R0 (reproduction number) of the virus was estimated to be ~2.3, as many viruses in the coronavirus family have a similar transmission rate. Which means that every person carrying the virus will infect another 2.3 people on average.

Newer research suggests that the reproduction number is even higher (3.25 ≤ R0 ≤ 3.4). Which is huge, even if it doesn’t sound like it.

If the 1st patient infects 2.3 other people, then after 10 rounds there are 4,142 infected people. If the 1st patient infects 3.4 other people, then after 10 rounds there are 206,428 infected people, almost 50 times as many. So small differences in R0 can have *huge* implications as to how easily the virus is spread and how many people get sick.

The size of R0 also has important implications on how to stop the virus. We don’t need *everyone* to be immunized in order to stop the virus. There is something called “herd immunity”, which means that if a critical percentage of the population is immunized, the virus will no longer be able to spread and will die out.

The critical percentage is (1 – 1/R0). Using an R0 of 2.3, that implies 56.5% of the population has to be immunized before the virus will die off. Using a R0 of 3.4 implies 70.6% of the population will have to be immunized. This is not good, as only 45.6% of people get their annual flu vaccine, so reaching a higher vaccination rate is going to be difficult and will likely require mandatory vaccinations.  Antivaxxers are likely to get a lot of people hurt if they resist.

  • What will happen in the US if the virus gets here?

From reading some CDC papers, their most likely response to the virus is likely to be 1-3 weeks of “snow days”, people voluntarily staying home in order to short-circuit the virus’s transmission, with the additional hope that we get an early warm spring that helps bottle up the virus until fall.

On the assumption that “snows days” are in our future, here are some essential preparations:

  • 3 weeks worth of food for your family. If you’re a typical American, you probably already have this, but it’s worth double-checking.   More probably wouldn’t hurt.
  • 3 weeks worth of food/supplies for your pets.   Also medicines, litter, etc.
  • 3 weeks worth of drinking water. For most people tap water is fine, but you may want to have some bottled water as well in case there’s problems with tap water.
  • Refills of any crucial prescriptions you may have. A large number of pharmaceuticals are made in China, so there is a growing likelihood of shortages in coming weeks.
  • Cleaning supplies. Soap, cleaning wipes, alcohol gel or rubbing alcohol, peroxide, white vinegar, trash bags, toilet paper, paper towels.
  • Entertainment. It’s crucial both for yourself and for the general public that you stay at home for the full quarantine period, so find ways of keeping yourself occupied so you don’t get cabin fever. Buy that book you wanted to read, splurge on some movies, etc. Whatever works for you.

Since the entire purpose of home quarantine is “not leaving your home”, the above should suffice for most people. But there are folks who have to leave their home, either because they have critical jobs or they experience an emergency of some sort. In that event:

  • Wear a face mask. A N95 or higher is optimal, but *any* mask will somewhat reduce chances of being infected. Face masks need to be replaced every 2 hours to maintain effectiveness. If you don’t have a face mask, wear a bandanna or shirt wrapped around your mouth. This will offer some marginal protection, though admittedly not much.
  • Eye goggles or a face shield. The virus can be transmitted if viral particles contact your eye.
  • Have a quarantine room in your home, so you can enter/leave without endangering anyone else. A garage makes a very useful one.  Take your clothes off before entering the home and leave them there if possible, and clean yourself and anything you have touched extremely thoroughly with soap and water. Once done, if you have the time to do so, wait in the quarantine room for a few hours, to further reduce the chances of transmitting any residual virus.
  • Viruses in general prefer cold, dry air, which is why colds/influenza primarily occur in the winter. If you can, heat your house or at least one room as warm as you can comfortably tolerate, and have a humidifier, tea kettle, or boiling water on the stove going to increase the humidity of the space.   Note that this isn’t going to “magically” sterilize an infected room, it just reduces the virus’s ability to survive on surfaces over time.
  • Keep your hands in your pockets whenever possible. The virus can be transmitted by touch, and humans touch their faces all the time without realizing it. The easiest way to avoid touching potentially infected items and then touching yourself is to keep your hands in your pockets whenever you can.
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Bubble, Bubble, Toil and Trouble…

Two months ago I wrote a blog post about where I thought the economy was heading.   Since then, I’ve learned some things which suggest more pessimistic outcomes.  I wanted to write them down, both for my memory and to inform others.

Assuming that a recession is headed this way, it would be quite helpful to be able to answer four basic questions:

  1. How big is the bubble?
  2. What pops the bubble?
  3. When does the bubble pop?
  4. How do we get back to normal?

For #1, I recently learned a very useful measure to gauge the size of bubbles:   Household Wealth vs GDP.  Household wealth measures the value of everyone’s assets if they were sold at that instant at the current market price.  For instance, if you owned 1,000 shares of Beenz.com, you might be a millionaire in 1999, or dead broke in 2002.

As a rule, household wealth shouldn’t grow any faster than GDP.   It’s a way of saying “the sum of everyone’s individual wealth should grow at the same rate as the entire country’s wealth”.    So when household wealth *does* grow faster than GDP, it indicates that asset prices are in a bubble.

So what does it look like today?


Ruh-roh…

In 2001, stock prices were inflated.   In 2007, home prices were inflated.   Today, it looks like *everything* is inflated.  And the asset bubble is substantially bigger than the one that caused the Great Recession.

To put it delicately, this is unlikely to end well…

As for #2 (What pops the bubble), I have little new information on that, just various bits of speculation on my part.   The bubble doesn’t have to *pop* per se.   A “good” economic correction could slowly and safely let the air out and we could avoid serious problems (though a “good” correction would still feel painful, just less so).   The best advice I can give you is still “whatever it is, don’t be around when it *does* pop”.  And if Italy starts having financial problems, be *very* afraid.

For #3, I mentioned last time about the yield curve, and how yield curve inversions predict recessions.    Since then, the yield curve has reverted to normal.   Isn’t that great?


Nope.   It’s bearish, and a sign that a recession may be coming sooner than I thought two months ago.    For the last three recessions, only a few months passed between the yield curve returning to normal, and a recession striking:

  • 1990 Recession: 7 months
  • 2001 Recession: 1 month
  • 2008 Recession: 3 months

It is difficult for me to believe the economy is going to crash in the next few months.  Honestly, if you pointed a gun to my head I would guess the end of 2020/beginning of 2021.     I certainly don’t *see* anything that could do it in the next few months.   But neither did most folks in 1990, 2001, and 2008 either, so it’s completely possible this time too.

But…   Is there any other way of guesstimating recessions?   Turns out, now there is!  Earlier in 2019, a Federal Reserve economist by the name of Claudia Sahm discovered the “Sahm Rule”, which is garnering a *lot* of attention in economic circles.

The Sahm Rule states that when the three-month average unemployment rate rises half a percentage point above the low of the previous year, the economy has just or is about to enter a recession.

So where does the Sahm rule put us?


Looks like we’re in the clear.  Or maybe not…

It turns out, the unemployment low for the year was 3.5% in September 2019.   Unemployment has since risen to 3.6% in October.   That may merely represent random noise.   Or it could be a sign that things are about to go south.   Using Sahm’s rule, if unemployment reaches 4% in the next few months, something wicked this way comes…

I strongly recommend folks pay attention to unemployment numbers going forward.   If unemployment heads the wrong way a second time, it’s time to at least contemplate scrambling for the exits.

Also, watch how Wall Street behaves.  You can bet that every firm on Wall Street worth its salt is aware of the Sahm rule and is watching it like a hawk.   Wall Street usually has an accurate estimate of unemployment before the government releases the official numbers.  If they determine Sahm’s rule is pointing towards a recession, they may run for the exits simultaneously, which is likely to cause asset prices to plunge dramatically, and may be sufficient to kick-start a market crash.

And as for #4, we know that the Fed is nearly out of monetary ammo.   Except for the recessions in the early 80’s (which were artificially created by the Fed to get 70’s inflation under control), the Fed normally drops their rate by ~5% after a crash to help get the economy moving again.  But they *can’t* do that when the Fed rate is only 1.8%.

And the Trump tax cuts for billionaires increased the deficit by over $1 trillion, limiting our ability to use fiscal stimulus when a recession hits.   So government’s ability to pull us out of the fire is going to be a lot more constrained this time than it was in 2008.

But corporations can also take advantage of crashes to hire new employees and extend into new markets.   Will they help save us this time?    Unfortunately, probably not.

Instead of learning their lesson in 2008, corporations have piled on more debt than ever.   Currently corporate debt is 46.6% of US GDP, an all-time high.


But worse, they *didn’t* use this debt to generate economic value by investing in new products or growing their business.  Instead, they largely used it to finance stock buybacks, which made current stockholders (and the CEO’s running the businesses) quite wealthy.   CEO departures are on pace for a record year, likely because they’re trying to get out of Dodge while the getting’s good.

The consequence of the enormous debt overhang and failure to invest in long-term economic growth are likely to hamstring companies once a recession hits.    You may have read stories about how “leveraged buyout firms” extract the equity of a company, leaving behind a husk that quite often fails due to the burden of debt placed on it.

Instead of a leveraged buyout firm doing it to a single company, CEO’s and executives around the country have done that to a significant number of *their own companies*.     Not only are companies not going to be able to help save the economy, a surprising number of them are likely to fail when a recession hits.

In summary, we know that the asset bubble is *really* big, even bigger than the Great Recession bubble.   Something is likely to happen in the next year.  And our ability to get back to normal is crippled compared to last time.

2020 is looking to be a *mighty* interesting year…   Better buckle your seat belts.

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The Next Recession…



I.  Introduction

“For now we see in a mirror, darkly; but then face to face:
now I know in part; but then shall I know fully” – I Corinthians 13:12

The past year I have spent a lot of time contemplating the economy, what is likely to happen the next few years, and how to invest accordingly.  Having spent a decade struggling to emerge from the shadow of the Great Recession, it is uncomfortable to think that another recession is lurking just around the corner, yet there are growing signs that one is.

I am writing this to help organize my own thoughts, as well as help others understand and encourage conversation.   I may not be exactly right.   In fact I’d be rather shocked if I were.   But as John Maynard Keynes ventured, “It is better to be approximately right than precisely wrong.”  And what’s the point of making predictions if you don’t make them public so other people can ask questions and challenge your thinking?

To be clear, it’s nigh impossible to predict exactly *when* a recession will occur.  A recession is rather like an avalanche in that regard. You can’t predict *which* snowflake will start an avalanche. But when you see a large pile of snow perched precariously on the mountain, you should probably think twice before going skiing that day.

Similarly, you can’t really predict in advance which event (Brexit, Trump tariffs, Hong Kong, war with Iran, collapse of consumer confidence, sovereign debt crisis in southern Europe, or one of those mysterious Unknown Unknowns) will puncture the economic equilibrium and tilt us into a recession. But you *can* say with good confidence that conditions are coming into focus to allow something like that to happen.

II. Sign that a recession is coming – The Yield Curve

“Why is it when you yield, I feel like the one who has been conquered?”
– Judith McNaught


When it comes to economic indicators for forecasting recessions, the “yield curve” is usually considered the most reliable.  So what is the yield curve? 

Our government sells Treasury bonds that have different maturities (3 months, 2 years, 10 years, and several others). The yield curve is simply the interest rate on the longer-term Treasury minus the interest rate on the shorter-term one.   For example, if a 10 year Treasury has an interest rate of 3%, and a 3 month Treasury has an interest rate of 2%, then the “10 year/3 month” yield curve would be 3% – 2% = 1%.

Investors love making money but hate risk.   The longer you remain invested in something, the more risk you take, of inflation wiping out your investment, or of missing a better investing opportunity elsewhere.  Investors want compensation for the risk of locking their money up for a longer time.  So interest rates on longer-term bonds are usually higher than rates on shorter-term bonds, and the yield curve is normally positive.

When the yield curve inverts, it means that short-term Treasuries have *higher* interest rates than longer-term Treasuries.  Investors buying short-term Treasuries see higher risk on the near-term horizon, and want to be compensated for bearing that risk.

A so-called “yield curve inversion” has preceded every recession since the 1950’s except one (the economy slowed but avoided a recession during the 60’s). And once the yield curve inverts, a recession almost inevitably follows within 12-24 months.  Looking at the yield curve, we can see it inverted in May 2019.   Which doesn’t bode well for 2020.

How does the yield curve “predict” recession?  Banks earn a profit by “borrowing short and lending long”. That is, when you go to the bank and ask for a mortgage or car loan, they borrow money at the (usually lower) short-term rate, and lend it to you at the (usually higher) higher-term rate, and make money from the difference between the two rates.

When the yield curve inverts, the “high” rate is lower than the “low” rate.  It makes lending unprofitable for banks, so they compensate by tightening lending requirements and refusing to lend to marginal borrowers. This makes it difficult for weaker companies, which often have to let employees go or cut back their growth in other ways.  Eventually the economy is sufficiently weakened that an event can tilt the economy into recession.  So an inverted yield curve doesn’t *predict* recessions, it actively helps *cause* them.

While I believe the yield curve is pointing the way to a recession in the next 6-18 months, there are also important signs that as of yet do *not* show any sign of a recession.  For example, if Wall Street was overly worried about the overhang of corporate debt, the interest rate on so-called “junk bonds” would be rising to compensate for the perceived risk.   In the 2001 recession, there was a long, slow rise on “junk bond” spreads that actually started 3 years earlier in 1998, and in 2007 there was a steep and rapid rise in junk bond spreads roughly 6 months before the Great Recession was officially called.  And yet, looking at junk bond rates,  there is no sign of that happening yet

A recession will happen when it happens, and not when economists want it to happen.   In fact, it’s completely conceivable that the US economy manages to dodge all the potential dangers and avoids a recession altogether.   That said, I wouldn’t bet on it.

III. What shape will the next recession likely take? – A US “Lost Decade”

“All happy families are alike.
Each unhappy family is unhappy in its own way.” – Leo Tolstoy

The good news: there are few signs that the next recession will be as *deep* as the Great Recession. Consumers aren’t in nearly as much debt as before, and banks are better capitalized.   So we are unlikely to see a repeat of the Great Recession.

The bad news: there are signs that the next recession may last *longer* than the Great Recession.

At some point in the next year or two, some event is likely to knock the economy into recession, and once there, we won’t have the usual tools to get ourselves back out.  And the corporate debt bubble is likely to constrain growth for years.

This scenario is similar to Japan’s “Lost Decade”.   Japanese companies experienced vigorous growth in the 70’s/80’s, which encouraged speculation.   When their stock market crashed, those companies suddenly found themselves trapped by debt payments they could no longer afford and could not refinance.   So over-leveraged companies were forced to prioritize debt repayment over growth/hiring, which kept Japan’s unemployment rate high, and helped extend Japan’s recovery into a decade-long slog.

Japan’s “Lost Decade” was a textbook example of what economists call a “balance sheet recession“.   However, while there are certain similarities (most notably the overhang of corporate debt as well as the impotence of conventional monetary policy), the US situation is somewhat different from Japan’s.   

On the positive side, unlike Japan, most US companies are unlikely to be in true danger of insolvency.  The ones borrowing the most debt have plenty of money stashed away, but that money is often held abroad to avoid triggering US corporate taxes.  So even though they have funds on hand, they may still choose to curtail hiring to avoid paying taxes.  This suggests that Congress might be able to spur the economy by passing legislation encouraging/compelling companies to repatriate money from foreign subsidiaries.

IV. How do we recover and get back to normal? – Fixing inequality

“All of this has happened before, and all of it will happen again.”
– Battlestar Galactica


You may have heard someone mention inequality without understanding what it meant.   Inequality is simply a measure of how unequal income or wealth is.   By definition, the wealthy have more money than the poor.    But inequality can grow or shrink, and have extremely consequential economic effects.   

As you can see in the graph above, inequality hit record highs right before the Great Depression *and* the Great Recession, and the 1950’s-1970’s that are normally regarded as a golden age of prosperity for most Americans had much lower inequality.   That is highly unlikely to be a coincidence.

The poor and middle class spend most or all of their income, often from necessity.  Houses, food, utilities, cars, children, healthcare, education often use up their entire salary, so that they couldn’t save even if they wanted to.  But the wealthy have the ability to save a significantly part of their income, which they invest so they can become even wealthier.   

But over the long term, this can cause serious economic problems.   The wealthy earn the lion’s share of their wealth from the stock market, while the poor and middle class see their incomes increase roughly at the same rate as GDP.   On average, the stock market grows ~7%/yr in real dollars, significantly faster than the average 3.2%/yr of the economy as a whole.  So not only do the wealthy start off with *more* money, their money grows *faster* than everyone else’s, which causes inequality to increase over time.   (In fact, historically inequality has only been reduced by war, plague, or other natural disasters, which is one reason why I hope we choose to do so voluntarily this time.)

Please note that I’m not calling the wealthy “evil” or “selfish” (though a certain subset of them *have* used their wealth to game our nation’s laws to their benefit at the expense of everyone else).   They’re merely doing what’s in their own best interest, without regard (and often without realization) about the deleterious effects their wealth has on the economy as a whole.

Some may denigrate worrying over inequality as mere “greed”.   Who cares if a wealthy person has a luxury mansion, as long as you’re doing good?    And if it were that simple, it would probably be true.   While I would love to own a home like Bill Gates, I certainly don’t *feel* poor just because his home is nicer home than mine. 

The problem is that inequality has macroeconomic effects which *hurt* the poor and middle class.   US’s tax policy since the 1980’s has allowed the wealthy to accumulate a “savings glut“.  The pile of money the wealthy wants to save has grown larger than the available investment opportunities. Econ 101, when supply exceeds demand, profit falls.

For example, we can see here how the “savings glut” has caused yields on 10 year US Treasuries to fall since 1980:

We can also see similar effects in the stock market.   Below is a graph of the Shiller PE ratio.  The ratio gives the Price/Earnings ratio based on average inflation-adjusted earnings from the previous 10 years, and as such, provides a useful estimate of whether the stock market is “overvalued” or “undervalued”. 

 From the graph above, you can see two things:   1) a long-term growth trend in “overvaluation” started in 1980, and 2) today the stock market is highly overvalued by historical standards, exceeded only by the Great Depression and Great Recession.  

Just as a *falling* bond yield means less profit for new investors, a *rising* stock market overvaluation makes it relatively more expensive for new investors to buy stocks, as they are paying a growing premium price relative to earnings.   The profit here is falling too…

As the “savings glut” has persisted across both Republican and Democratic tenures in office, the fault doesn’t lie with any particular political party, as they both have a largely unblemished track record of kowtowing to the wealthy at everyone else’s expense.  And as inequality has been a problem decades in the making, it will likewise probably require decades to correct.   So the sooner we start, the better.

Falling long-term interest rates are great if you’re borrowing for a home or car. But they are bad if you’re a retiree depending on CD/bond income for your retirement, or if you’re trying to save for retirement.   The average 50-59 person only has $174,100 in their 401k, and a 5% return only yields $8,705 per year.  Even combined with Social Security, the average person will only have ~$25,000 per year to live on.   Meaning that many retirees will likely be working until they die of old age because they simply *cannot* afford to retire.

And on a larger scale, the “savings glut” is hindering the Federal Reserve’s ability to fight a recession.   As mentioned earlier, when a recession strikes, the Fed has normally lowered rates by ~5%.   This makes borrowing cheaper, which encourages investors to borrow and spend on homes, factories, infrastructure, and other things which help put people back to work and rev the economy back up.     But with rates that will likely hover below 2% within a few weeks, the Fed simply *can’t* stimulate the economy as much as it used to.  Once a recession hits, the end result is likely to be more poor and middle-class people unemployed for longer periods of time.

The flip side of the wealthy’s “savings glut” is an “income deficit” for the poor and middle-class.  For several decades starting in the late 1940’s, whenever worker productivity increased, their incomes increased proportionately, which helped inequality relatively low and led to a strong and growing middle class.  Starting in the mid-1970’s, that relationship broke down.   Money that had previously been shared with workers increasingly started to be horded by the owners of the companies instead.   Consequently, for many workers their incomes either haven’t grown in real terms in decades, or have actually fallen

America has previously experienced eras of “creative destruction” from automation that have eliminated entire job sectors.   You’ll notice there’s no longer a huge horse and buggy industry, as those jobs were destroyed when the automobile was invented.  The current problem with automation is two-fold:   The rate of automation is increasing so that jobs are being destroyed faster than new ones can be created, and the rewards for automating are accruing to an ever-shrinking portion of wealthy Americans.   So automation is hastening an already painful increase in inequality.

There are two ways of tackling the “savings glut” at the heart of inequality:  From the “demand side”, by using deficit spending to “create” new investments, or from the “supply side”, by taxing the wealthy so they have less to save, and distributing it to the poor/middle class to counteract their “income deficit”.

The deficit spending required by the “demand side” has a huge downside. Except for a brief period during Bill Clinton’s presidency, the federal debt has increased unabated since shortly after World War 2. But someone, someday will eventually have to pay that debt. And there are growing signs that it will be *this generation*. This is no longer our grandchildren’s problem.  It is our grandchildren’s grandparent’s problem.

There are three ways to pay for deficit spending: by raising taxes on the wealthy, by cutting services (mostly used by the poor/middle class), or by debasing the dollar via inflation (which mostly hurts wealthy lenders).  As no politician is likely to get elected on the promise of raising taxes or cutting services, seeing the dollar debased is the most likely outcome.

By contrast, increasing taxes on the wealthy has fewer negative side-effects. Not only does it eliminate the savings glut, we can use those taxes to pay the debt, pay for infrastructure, pay for healthcare and education, and cut taxes on the poor/middle class to reduce the income deficit.  And their increased income would likely yield a roaring economy.

As our country is run by the wealthy, for the wealthy, our elected officials have only tried deficit spending over the past 4+ decades.  And all most of us have gotten from it is more debt, more inequality, and a more unstable economy.   Inequality will keep us caught in a cycle of worse-than-usual recessions and weaker-than-usual recoveries until such time as we get serious about fixing it.

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