Strong Views Lightly Held

I didn’t understand how far the “pro wrestling” rot had spread.  McCarthy delivered what his radical wing wanted.  The wackadoodle’s non-negotiable demand was  a stage on which to go down in glorious, oppositional defeat.  He gave them a stage to strut on; making loud demands; striking defiant poses.   The policy result – universally scored to be a nothing-burger – was totally beside the point.

My worry about the debt ceiling was that MCarthy wouldn’t be able to get “enough” Republican votes to pass a compromise debt ceiling bill.  I was kinda right on that score.

The bill gained 165 votes from Democrats, outnumbering the 149 from members of McCarthy’s own Republican party.

I was wrong to think that McCarthy would not bring a “majority Democrat” bill to the floor.  He did.

I was MUCH MORE wrong to think that his House colleagues would care about the content of the bill.  I assumed they would care about the substance of the policy.  Economist and Historian Brad DeLong puts it well.

Could it be that it was all a game of Dingbat Kabuki? Could it be that what the Republican Rite wanted was for Kevin McCarthy to show that he would push things to the deadlined, and they did not care whether he won substantive policy victories? Was it just McCarthy saying “I will give you a quick and easy substantive budget negotiation if in return you spend two months acting like I am powerful and you are scared”?  https://braddelong.substack.com/p/briefly-noted-for-2023-05-31-we

That vote count is kind’ve encouraging over the next few years.  The US is not a parliamentary system, but we may be entering into an era of coalition government.  If that loose coalition of 165 Democrats and 149 Republicans hangs together, we could move beyond the extreme government dysfunction of the past decade.

The wackadoodle wings of both parties get to do their performative dances in front of the cameras.  The actual business of the nation gets quietly handled by that centrist coalition.  If we have a moderate in the White House (a big if) that cobbled-together system could actually be pretty – functional?

The worrying thing is that Pro Wrestling rot.  This is largely a Republican phenomena.  How far does it spread?  How deep does it go?  Janan Ganesh sums it up nicely in the FT (paywall).

I am no longer sure that populist voters want to win the culture war. Just being in it gives them meaning. If anything, there is more group identity in losing, more solidarity under siege than in triumph. If I am right, none of the governor’s arguments against Trump — his electoral repellence, his boredom with detail — are half as wounding as he hopes.  https://on.ft.com/43s3Equ

The only part he misses are the very worrying strains of Southern (and Western) “Lost Cause” mythology under the surface.  Glorifying “noble defeat” is intertwined with a lot of nastiness in American history…

Nihilism is also just socially toxic.  It eats away at the community feeling that underpins a nation.  In that sense, this coalition government “victory” is just appeasement.  The more we accommodate the madness, the more it will demand.  That is very worrying…

My (wrong) view from a week ago.

In the “Rebel Without a Cause” game of chicken, James Dean jumps.  The other guy’s jacket catches in the door and he plunges to his death (video below).  I think too many people are assuming we are James Dean…

A lot of people have also forgotten what happened the last time a “Grand Bargain” bill got to the House floor (under Boehner and Obama).  Boehner couldn’t corral the votes.  The bill (which read like a 1990’s Republican wish list) died an ugly death at the hands of a fractious Republican caucus.  Ask yourself –  Has the average Republican House member gotten more or less compromise-minded in the last 10 years?

I have no idea where the debt ceiling crazy train ends.  I do see a very narrow path for the widely assumed “moderate compromise” deal ever making it to the House floor for a vote much less passed.

Debt Ceiling – Are We James Dean or Are We the “Other Guy?”

In the “Rebel Without a Cause” game of chicken, James Dean jumps.  The other guy’s jacket catches in the door and he plunges to his death (video below).  I think too many people are assuming we are James Dean…

A lot of people have also forgotten what happened the last time a “Grand Bargain” bill got to the House floor (under Boehner and Obama).  Boehner couldn’t corral the votes.  The bill (which read like a 1990’s Republican wish list) died an ugly death at the hands of a fractious Republican caucus.  Ask yourself –  Has the average Republican House member gotten more or less compromise-minded in the last 10 years?

I have no idea where the debt ceiling crazy train ends.  I do see a very narrow path for the widely assumed “moderate compromise” deal ever making it to the House floor for a vote much less passed.

Lets review the politics how we got here to maybe see where it ends.

1. The Democrats could have just raised the debt ceiling in the Lame Duck session.  They didn’t – possibly fearing it would give Manchin leverage to re-negotiate the IRA.  But they didn’t…
2. I think the (stupid) White House bet was “McCarthy will never get his herd of cats in line to even pass a bill, so we will slide into the deadline with “Republicans in disarray” headlines.  We win politically.  So lets plan for that…“
3. McCarthy actually got a bill passed.  Never mind that was only with this late night caveat (as reported at the time) “please just vote for this its a negotiating tactic it will never become law.“
4. That “compromise” bill has worked as designed.  McCarthy is now engaged in “serious” one on one talks with Biden.  Boosting his image and making the Republicans look competent.  The White house is now on the back foot every time McCarthy stands in front of a microphone and says “Biden isn’t being serious etc etc. “

A lot of people are following that political game and assuming it will end with the White House and McCarthy agreeing some sort of compromise and then that passing the House.

But McCarthy’s current “compromise” bill is too far right to get any Democratic votes or White House approval.  Yet it only got a Republican majority after assurances that it would never become law.

So when McCarthy comes back with a compromise that has moved left, what do you think his chances are for getting a straight majority vote?  It is possible.  But the House Republican caucus has a lot of people who treat the job as full time performance art – like WWE pro wrestling.  They are playing a character on TV.  “Compromise” isn’t in their story arc. 

What are McCarthy’s chances of getting Democratic votes?   That depends on the bill…  There are votes to be had – although there are also fewer Democrats who still quaintly believe their job is to govern.  But the more Democrats that sign on, the more “performative” Republicans will feel compelled to sign off.  Because “compromise” is a dirty word in MAGA politics these days. Compromise is something “weak” Democrats do.

The other dangerous assumption is that Democrats will (or can) keep us from going of the cliff.  Republicans are comforting themselves that (said with a slight sneer) “Biden’s brand is “compromise,” so of course he’ll give it up in the end…”  I think this misses how embattled the Democratic party has become over these years.  The embittered spouse tired of knuckling under “for the sake of the family.”   There are a lot more Democratic House members playing the pro wrestling game these days too…

So how does this all sum up?

1. McCarthy is negotiating to negotiate.  Loving the present moment, but dreading the end game   Because “the guy who needed 14 votes to become Speaker” rightly  fears he can’t actually deliver…
2. The White House has stuck itself.  Biden can’t walk away.  So he keeps negotiating.  Understanding that “negotiations” are the point here, not a “negotiated outcome.”
3. We are watching the performance assuming it all gets tidied up in the end…

We are all partly complicit in how our politics has become pro wrestling.

The risk is that, when it comes time to wrap it all up and jump from the cars, we realize our jacket is caught.  Plunging over a cliff isn’t in James Dean’s story arc, but maybe we are “the other guy” in this script…

<https://youtu.be/BGtEp7zFdrc>

When you have indicators point every which way like this, the “right” answer is…

Don’t put too much weight on any one indicator.  Something is clearly off normal trend.  Guess from the present situation.  Don’t rely on past examples.

But most people don’t look farther than the yield curve, which is definitely predicting a recession.

On the other hand, Labor markets and another “real economy” indicator are showing no reason to worry.

So tread carefully.  Pasting in links below.  Data charts sometimes come in wonky.

The Yield Curve (which is the only thing most investors watch) is screaming “68% chance of a recession.” Although its last “prediction” was really the COVID recession.  I have a lot of trouble believing the bond market foresaw COVD.  But maybe we were fated to have one without COVID?  https://www.newyorkfed.org/research/capital_markets/ycfaq#/interactive

The “Sahm Rule” says “no recession ahead”  This is based on changes in unemployment with an even better track record than the yield curve  https://fred.stlouisfed.org/series/SAHMCURRENT

Nothing showing on the “Smoothed Recession Probabilities” Indicator ” Smoothed recession probabilities for the United States are obtained from a dynamic-factor markov-switching model applied to four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales.” https://fred.stlouisfed.org/series/RECPROUSM156N

The current consensus on the Debt Ceiling stand-off seems to be “There will be a lot of noise and drama and then they will pass a compromise and we move on.  Just like has happened in the past.”  I see higher risk the Debt Ceiling game of chicken ends up going off the cliff into a constitutional crisis.

Remember that a Bill doesn’t make it to the House Floor unless the Majority Leader allows it…  Any compromise package that can pass the Senate is going to be “too far left” for a lot of McCarthy’s caucus.  But House Speaker McCarthy will have to actively choose to bring any debt ceiling “compromise” legislation to the floor.

He can only lose 4 votes.  You have to assume that more than 4 Republicans will vote against any deal that could realistically  pass the (Democratic) Senate.  So McCarthy would likely have to bring a bill that passes on Democratic votes.   Does McCarthy have the political capital and courage to do so?

The same dilemma mortally wounded Republican Speaker John Boehner in the Obama years when the Republican House Majority had a lot more moderates…   That would be a tough hand for McCarthy even if he were a strong Speaker.

McCarthy is not a strong Speaker.  It took how many votes to get him elected?  

McCarthy is also not an obvious profile in political courage.  How much did he kowtow to the extremist wing of his party to win that squeaker of a Speaker election?

I also hope to see a compromise, but I’m not so hopeful.  This scenario is predicated on 2 questionable assumptions – especially #2:

1. Are there actually enough D and R “moderates” left to vote a compromise package through?
2. Will McCarthy actually bring a compromise resolution to a vote?

Working from right to left, McCarthy will likely lose one or more Republican vote for every Democratic vote he gains.  So if McCarthy loses more than 4 Republican votes, any bi-partisan compromise bill will have to shift pretty far left.  Even that assumes there is a workable coalition in the center for anything but a straight debt-ceiling raise…

This also presumes any Republican house member is willing to sign up to a compromise.  Look at what happened to the Republicans who voted to impeach Trump after Jan 6th.  Is that a sure bet?  The same calculus applies (less strongly) to House Democrats.

The biggest problem is that McCarthy does not have a way to avoid putting HIS name to that bill.  He knows that risks his speakership and quite possibly his job. Does he take that risk?  Could even the most courageous Speaker conjure a “moderate” majority out of the current congress?

I am hopeful, but I do not like the odds.

Wrote this today, figured I’d share.  A lot of people have been comfortably riding a “mega recession ahead!!!” macro call for 18 months now. The sell-by date on that bet is coming soon.

If that “big recession, big spike in unemployment” bet does not pay off soon, it might stop being a self-fulfilling prophecy. 2H spending un-freezes at some (decent) level. The Fed eases up (saving the banks). We learn to live with 3%-4% inflation. Remember, the 1990’s weren’t all that awful (see Thought Experiment 1 below).

Yes, Economic data keep pointing to a slowdown. No, the data are are not (yet) saying “mega-crash in the next 3-6 months.”

What if things don’t crash soon? How long can the Fed hold rates here? If the yield curve stays inverted too long, it risks driving the banking system and a lot of Commercial Real estate off a cliff… The Fed has been hoping employment would fall off before it un-inverting the curve.

The current market bet (right now) seems to be that the Fed will jump out first in this game of chicken. Cutting rates sooner vs later and flattening the curve. The market bet may change. We might go off the cliff.

Please don’t staple a “no recession” forecast to my forehead. Credit is tight and getting tighter. That will definitely add to the slowdown we already see. We are definitely slowing down. The data show that.  I am just noting that “slowdown” might not be enough deceleration fast enough for the assumed Fed game plan.

We’ve had 18 months for rates – raised far higher than anyone expected – to do their work. We mostly have a banking crisis to show for it Maybe macro gets really really ugly in the next 3-6 months? But if it doesn’t?

• Thought experiment 1 – no-one remembers the 1970’s inflation era (scary music here), but not many people remember the 1990’s either (happy boom times music here). You wake up in 1995. PCE inflation is ~4% – heading downwards with forward expectations are well-anchored. Unemployment is below 4%. We are on the verge of a massive AI-driven technology innovation wave. Would the market be feeling depressed/worried? Or would markets be pretty happy?

• Thought experiment 2 – If inflation is at 4% and trending down (or the long-term surveys and TIPS aren’t trending it up), will the Fed have the political cover to keep pressing? A steeply inverted nominal yield curve is already threatening a banking and Real Estate crisis. Is the Fed really willing to risk that?

The block in the mental model is the Fed’s 2% inflation target. That target is hardly written in stone. It is only 10-11 years old. It led to 1% trend inflation in practice. We spent the 2010’s fighting deflation…

• 2% has been in place since… 2012.

• There is no formal academic support for 2%. It was basically pulled out a hat on a talk radio show in New Zealand.

• We’ve realized a 2% “target” ended up a de-facto ceiling. So trend inflation ended up at 1% trend (too low). Goodharts Law (see below)

• If we set the formal target at 3%, it would be the new de facto ceiling. Trend inflation would likely be around… 2%! That doesn’t sound too awful.

The political problem is how to you drop the 2% target and go to 3% without embarrassment? No clue. Probably just talk a lot about 2%, but let everyone know that’s not so serious anymore. Maybe use the debt ceiling crisis as cover to cut rates? But that does seems a better option than a crisis.

Goodharts Law strikes again:

Goodhart’s law is an adage often stated as, “When a measure becomes a target, it ceases to be a good measure”.[1] It is named after British economist Charles Goodhart, who is credited with expressing the core idea of the adage in a 1975 article on monetary policy in the United Kingdom:[2]

Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.[3]

It was used to criticize the British Thatcher government for trying to conduct monetary policy on the basis of targets for broad and narrow money,[4] but the law reflects a much more general phenomenon.[5]

A friend – probably sick of hearing about inflation – actually (gasp) asked for an update on Ukraine.  So here goes.

The last few 3 months would seem to support the “stalemate” view of the war.  Except for one minor detail.  The Russians have actually been pushing an offensive with pretty much everything they’ve got.  They just don’t got very much left…

You don’t have to be a military expert to conclude that the attacking side is in deep doo-doo when a “big push” offensive is indistinguishable from “stalemate.”  The Russians have fought themselves to an exhausted standstill.

Ukraine is preparing its own offensive.  With luck, they will punch through somewhere.  If they do, they have a pretty good shot at precipitating a rout – see “exhausted standstill.”  Will Ukraine get a breakthrough?  Napoleon (apocryphally) gives us the most honest answer.

I would rather have a general who was lucky than one who was good. – Napoleon Bonaparte

Watch for a sharp shock campaign of farther-behind-the-lines strikes.  Followed by a big push in the place(s) Ukraine thinks the Russians are weakest.  What specific territory they capture doesn’t matter nearly as much as getting far enough behind enough Russians to spark a rout.  The target is the Russian Army itself, not the geography.

Ukraine does bring a lot to make its own luck.  They…

• …can choose time and place.
• …have a HUGE number of freshly trained (albeit green) troops.  The units getting exhausted fighting Russia to a standstill around Bahkmut don’t need to carry an attack.
• … have brand new Western hardware.  A lot of this equipment is massively advantaged vs the Soviet-era gear the Russians (barely) have.  Russia is now bringing T-55 tanks (built in the 1950’s) to the front because they ran out of 1960’s era T-62’s…  Those things are all one-shot deathtraps for their poor crews.

Most importantly, Ukraine probably have a “secret” stock of longer-range missiles, bombs, and drones than can seriously disrupt Russian supply and command points.  They already did this did this out to a certain range with the HIMARS missiles.  With longer-range weapons, they can blast a whole bunch of new targets.  The way supply chain networks work, even small lengthening of the individual web links sums up to major reduction in total carrying capacity.

So if Ukraine’s luck holds, we could be looking at the War ending (in fact if not officially) in the next few months.  That would be a good thing for markets, the economy, and the world.

What if luck doesn’t show up?  What if Ukraine…

• …doesn’t break through?
• …does break through, but the Russians miraculously re-group and hold?

…then we might be facing a stalemate.

Ukraine will still have “won.”  If they don’t backslide into cronyism, they have won a place in modern, prosperous Europe.  They won’t be a Russian satellite.

Russia will still have lost.  It has destroyed  the weapons stockpiles it inherited from the Soviet Union.  Modern-day Russia doesn’t have the economic capacity to replace it all.  It will take ages to replace what little it can.  Putin is probably dead or near-dead before that happens.

But it would be really nice if Ukraine won big.  Because then Putin and all he stands for will lose big.  The Chinese lose big.  And that is, ultimately, hopefully a good outcome for the US and the world.

I’m not pushing some bolshevik agenda here.  The mechanics do matter.  If price increases led us into inflation, then price cuts might just lead us out?  A downward spiral of price-cutting would be great for inflation, consumers, and the economy as a whole.  It would suck for profit margins (and stock prices) in sectors that can’t maintain informal price discipline.  I am pretty sure Tech comes out OK.  I’m not too clear on what sectors would get hit.

The paper below (pretty convincingly) puts much of the blame for the recent inflation on informally coordinated price increases in key industry sectors.   The “emergency” of COVID created PR/political cover to organize those implicit cartels…

The dominant view of inflation holds that it is macroeconomic in origin and must always be tackled with macroeconomic tightening. In contrast, we argue that the US COVID-19 inflation is predominantly a sellers’ inflation that derives from microeconomic origins, namely the ability of firms with market power to hike prices. Such firms are price makers, but they only engage in price hikes if they expect their competitors to do the same. This requires an implicit agreement which can be coordinated by sector-wide cost shocks and supply bottlenecks.

The good news (for the economy) is that price coordination eventually breaks down in  informal (or even formal) cartels.  Price discipline cracks.  Someone starts discounting.

Arguably the great yearning for a sharp labor market recession is to avoid that collective breakdown.  Once price discipline breaks down, it can turn into a race to the bottom.  If firms can’t count on wage suppression to cushion the blow…

• FYI – It is an open secret that earnings calls are a great mechanism for price-signalling to other industry players.  You can coalesce that informal cartel openly with no legal risk.  But please don’t EVER mention that in polite company.  🙂

The paper also says out loud the unspoken reason – distraction! – so many people are so eager to over-focus on monetary policy and labor market drivers of inflation.  They desperately want to avoid talking about Real Economy price-setting & supply/demand dynamics. 

That conversation might lead to uncomfortable questions of just how competitive our “free market system” really is.  People might also start asking whether crushing the labor market is really the right solution to a problem created on the price-setting side of the inflation equation – Price = Profits + Costs (Labor, Capital, Land).

I keep poking at the consensus narrative around inflation because a lot of it sits on shaky foundations.  Most investors have unshakeable confidence in a set of monetary policy folk beliefs that have remarkably little support in real world economics or real world data.  I’m not trying to push some bolshie political agenda here.  I’m just trying to get a little closer to the truth than the stuff “everyone thinks is true.”  Seeing a little further towards the truth is kind’ve my day job.

Collective delusions can last for a long time (as I have learned to my pain).  But they, like informal cartels, eventually break down. Reality asserts itself – most likely here in the form of lower profit margins.  Possibly also higher wages, and a stronger Real Economy circular supply/demand dynamic than most expect.

So what industry is most vulnerable to a race to the bottom?  I don’t really know and, judging from price action – the markets aren’t too sure either.

• Definitely not Tech (my specialty).   Prices are already high and protected by other barriers to entry.  🙂
• Durable goods?
• Commodities?
• High fixed cost industry sectors – airlines?
• Consumer goods in general (discounts and sale  offers have started pouring into my inbox after a 2 year absence).

The above was sparked by a question asked in an FT newsletter.  For context, it is below.

It is natural to conclude that the post-GFC margin spike is somehow explained by monetary policy, given that after 2010 policy rates were pinned down and the Fed balance sheet growing. It is not clear to me exactly how this would work, however (remember operating margins are calculated before interest expense). Furthermore, there are other explanations available. Are companies underinvesting, boosting profits (and management pay) at the cost of future growth? This is the view of the economist Andrew Smithers. Or perhaps industry has become less competitive, allowing companies to pad margins without giving up market share? Or perhaps companies have had the upper hand against workers in recent years?

Full abstract of the paper.

The dominant view of inflation holds that it is macroeconomic in origin and must always be tackled with macroeconomic tightening. In contrast, we argue that the US COVID-19 inflation is predominantly a sellers’ inflation that derives from microeconomic origins, namely the ability of firms with market power to hike prices. Such firms are price makers, but they only engage in price hikes if they expect their competitors to do the same. This requires an implicit agreement which can be coordinated by sector-wide cost shocks and supply bottlenecks. We review the long-standing literature on price-setting in concentrated markets and survey earnings calls and compile firm-level data to derive a three-stage heuristic of the inflationary process: (1) Rising prices in systemically significant upstream sectors due to commodity market dynamics or bottlenecks create windfall profits and provide an impulse for further price hikes. (2) To protect profit margins from rising costs, downstream sectors propagate, or in cases of temporary monopolies due to bottlenecks, amplify price pressures. (3) Labor responds by trying to fend off real wage declines in the conflict stage. We argue that such sellers’ inflation generates a general price rise which may be transitory, but can also lead to self-sustaining inflationary spirals under certain conditions. Policy should aim to contain price hikes at the impulse stage to prevent inflation from the onset.

The real economy is clearly slowing.  But it may not be slowing fast enough to save Team Monetary Policy.  Says who?  The IMF.  After Hubris comes Nemesis…

The IMF’s revised forecast tells us the rate-rising fiesta risks damaging the financial system faster than it slows the Real Economy.   Politely saying The Fed-only campaign has failed.  We all risk calling in on that airstrike on our own positions.

“More worrisome is that the sharp [monetary] policy tightening of the past 12 months is starting to have serious side effects for the financial sector.”

The IMF is mis-using the term “side effects” given the blunt, inconsiderate nature of the interest rate instrument.  When you carpet bomb a place, everything an anything is a “side effect.”

All rate-hiking campaigns are a breath-holding, damage-taking contest.  The IMF forecast is just telling us rate-sensitive sectors can’t hold out much longer – banking, housing, Commercial Real Estate, auto-sales.  In that, the IMF is really saying the labor market and real economy  – free-market driven supply/demand stuff – aren’t cooperating with Team Monetary’s over-ambitious expectations.

To believe the warning in the IMF forecast, you have to believe that central banks will keep rates high until/as the banking system collapses.  Sampson bringing the temple pillars down upon himself.

I don’t think Central Banks have the guts or political support to pull down the temple.  The bond market doesn’t believe it either.  Especially when 3-5 year inflation expectations are undermining Team Monetary’s inflation horror-show narrative.

12-18 months ago. Team Monetary started this campaign confident a few points of rate rises would bring the Real Economy to heel.  Cue images of smug British colonial officers marching out – “a whiff of powder will teach those foolish natives a lesson.”

After 12-18 months of increasingly desperate yanking on the rates lever, the natives are not cooperating.  Actually, the natives are getting uncomfortably close to the thin red line of not-so-supremely-confident-anymore officers and other ranks.  See “Battle of Isandlwana” clip below  – especially the lunch party scenes…

The IMF report tells us Team Monetary is in the end game.  Holding the lines.  Hoping for a miracle.

They may yet get lucky.  A dramatic fall off in the real economy.  I don’t know if we will see that.  I do know that drop that must get mathematically more sudden every month that disaster fails to arrive.  As the IMF notes, the financial sector can’t hold out much longer.  The bond market seems the think its can hold until about year end.  If the real economy isn’t really tanking by June/July…

What if that hoped-for “miracle”  – an extraordinarily deep and fast recession?!? – doesn’t show up?  Then the choice is to either 1).  crash the financial sector (and big chunks of Commercial Real Estate and housing). 2).  Declare victory and move on.

What’s your bet?  1 or 2?  Am I missing a 3rd path?

I’ll leave you with a question to ponder.  What it we’d pulled a “targeted or automatic tax increases” lever 12 -18 months ago instead?  My guess…

1. …near-immediate drop in inflation expectations.
2. …relatively fast drop in measured inflation.
3. …minimal disruption to financial, banking, and Real Estate markets.  They still take a direct hit from tax increases, but no uncertainty-driven disruption.
4. …no bailouts.  Silicon Valley Bank would still be with us.
5. …lower deficit.  Opening up fiscal space for any downturn.

The only problem with the scenario above?  “Targeted tax increases” is a very uncomfortable phrase for a lot of people who really really want to believe the Fed has the one and only magic lever.  Almost as much as they want to believe their economic beliefs don’t have a political color…

FT summary of the IMF Forecast:

Pierre-Olivier Gourinchas, the IMF’s chief economist, said: “Below the surface . . . turbulence is building, and the situation is quite fragile.” “Inflation is much stickier than anticipated even a few months ago,” he said. “More worrisome is that the sharp [monetary] policy tightening of the past 12 months is starting to have serious side effects for the financial sector.”

In its twice-yearly full forecasts published on Tuesday, the IMF said the turmoil in the UK government bond market last autumn and the US banking turbulence last month showed the “significant vulnerabilities [that] exist both among banks and non-bank financial institutions”.

“Risks to the outlook are heavily skewed to the downside, with the chances of a hard landing having risen sharply,” the IMF said. Gourinchas told the Financial Times that, while the banking system was far more resilient than during the 2008 financial crisis, policymakers had to “think about what could go wrong”.

“We can all remember the long time between the failure of an individual institution, whether it was Bear Stearns or Countrywide,” he said, referring to institutions that failed more than a decade ago. “Every time, this was treated like an isolated incident, until it wasn’t.”

Battle of Isandlwana  https://en.wikipedia.org/wiki/Battle_of_Isandlwana

Eleven days after the British invaded Zululand in Southern Africa, a Zulu force of some 20,000 warriors attacked a portion of the British main column consisting of about 1,800 British, colonial and native troops with approximately 350 civilians.^[12] The Zulus were equipped mainly with the traditional assegai iron spears and cow-hide shields,^[13] but also had a number of muskets and antiquated rifles.^[14][15]

The British and colonial troops were armed with the modern^[16] Martini–Henry breechloading rifle and two 7-pounder mountain guns deployed as field guns,^[17][18] as well as a Hale rocket battery. The Zulus had a vast disadvantage in weapons technology,^[19] but they greatly outnumbered the British and ultimately overwhelmed^[20] them, killing over 1,300 troops, including all those out on the forward firing line. The Zulu army suffered anywhere from 1,000 to 3,000 killed.^[21][22]

We live better now because Agriculture went from ~95% of the workforce in the 1800’s to about 2% today.  How did that happen (mostly)?  Labor got expensive.  The industrial revolution gave people higher-paid, more attractive options to back-breaking stoop labor. So they left the farm.  Landowners either adjusted to that or they went bust.  Society was vastly better off for the disruption.

Last week I went camping (Spring Break with 2 toddlers – eeeek!).  We ate out twice in Santa Barbara, CA.  Both restaurants – family friendly mid-range – had converted over to counter service.  Place your order, take a number to your table, and a busboy would deliver it.  No more wait staff – even in a town with a major University. 

Counter-service restaurants are a micro example of how macro-level “productivity gains” manifest themselves.  Productivity gains = more output per unit of labor/capital/land.  You don’t get gains without a shift in how labor/capital/land are employed.  Making something more expensive (e.g. labor) is usually what drives that shift.

Higher Wages and Scarce Labor Force
=> Short Term Inflation
=> Long-Term Productivity Gains.
= Durable Wealth Creation

Labor costs do drive “inflation” shorter-term, but the long-term result is productivity gains if you let the free market work its magic.  If farm labor gets expensive, you buy a combine harvester.  If wait staff get too expensive, you switch to counter service.  The marginal returns from Do you want fries with that? no longer justify the marginal costs of hiring, retention, and wages.  The people who used to wait tables move on to higher-paying alternatives…

Society is long-term wealthier for that exercise of free-market choice.  Admittedly We don’t get “fries with that” anymore.  We also don’t toil in the fields or have butlers and ladies maids anymore.  The economy found more productive (and personally rewarding) uses for labor as its cost went up.

For some politics masquerading as economics unknown reason, a lot of “free market” commentators don’t want to let the actual free market do that work.

To them, rising labor costs must always be met with an immediate, panicked rush into a Fed-driven recession.  Throwing the long-term baby – productivity – out the window with the bathwater – short-term wage cost inflation.

But we also know productivity gains are the ONLY source of real wealth creation in an economic system.  Any other economic shifts just redistribute existing wealth.   Productivity grows the pie.  Everything else slices it differently.  The “free market” political agenda favors wealth re-distribution over real wealth creation…

It isn’t all politics.  I’ll close with a good tweet thread  by Micheal Pettis (economist who specializes in China) on how international factors have influenced the wage dynamic.

This is ideally how things should work. High wages drive automation, and automation drives wages up further as workers become more productive and businesses compete for workers. Meanwhile more spending by workers create more services jobs.

This is what used to happen in the US, but now, economies in a hyperglobalized world compete mainly by subsidizing manufacturing, directly or indirectly suppressing wages to do so. High wages now are more likely to drive offshoring than to drive productivity growth.
https://twitter.com/michaelxpettis/status/1644917558842388481?s=20

18 months into one of the fastest, steepest Fed hiking cycles in history, the market myth of an all-powerful Fed is looking pretty… mythical.

A year ago, “Team Interest Rate” was predicting economic Armageddon in January 2022 whilst expecting a MUCH SMALLER hiking cycle.  The high estimate for rate increases was about 1.75 points.  Those 1.75 points were expected to put the economy on the ropes.  A crushing recession was sure to follow.  The debate was whether it would be like 2001 (do.com) or 2008 (GFC).

18 months later, the Fed has raised rates by 4.5 percentage points.  One of the biggest rate hikes in history.  We have seen some impact.  How much?  We’ll never know.  But it is pretty obvious reality has not met prior expectations.

In bumper sticker terms, karma just ran over that dogma…

But most market commentators keep on seeing reality world through the lens of their preferred myths.  What and why do they see?

I recently struggled through “The Price of Time: The Real Story of Interest”  by a man who believes, deeply, in interest rates.  In his economic worldview, interest rates explain everything.  Rates drive everything. Rates are… everything?!?  It was a little weird (and a turgid read).  Yet I’ve seen it cited a few times (like in the FT).  So it clearly clicked with some folks out there.  People who see the Fed and rates as a one-factor economic driver…

He is sort’ve correct that interest rates REFLECT everything.  But do they drive?  Or are they driven?  Do we understand the world better by looking at the component things that make up “everything?” Or do we understand it better boiled down to a single, desiccated measure of that whole?

The right answer is we should look both ways.  Look at the forest and the trees.  The market consensus, centered around an unhealthy cult of “hallowed be the Fed.” is only looking at the forest…  Breezy talk of “a recession” avoids the specifics of a recession led by what sectors and caused by whom?

The whole over-focus on interest rates (and the Fed) as the “only thing that matters” keeps reminding me of Plato’s allegory of the cave (below).  Decades of experience has trained multiple  generations to just watch the shadows on the wall…

They see big, messy, vibrant economic and political chaos it reflects.  But (perhaps through disgust at that chaos?) they deeply believe the flickering shadows hold some greater truth than the chaos reflected.  Reality just goes on its untidy way.

In sum:  A lot of investors and reporters have grown up with a deep belief that “everything” can be explained by fine-grained movements of the Fed’s short-term interest rate target.  This faith was never well supported by academic economics or the Fed’s own research output.  Reality itself is also not cooperating.

Wikipedia – Allegory of the Cave https://en.wikipedia.org/wiki/Allegory_of_the_cave

In the allegory “The Cave”, Plato describes a group of people who have lived chained to the wall of a cave all their lives, facing a blank wall. The people watch shadows projected on the wall from objects passing in front of a fire behind them and give names to these shadows. The shadows are the prisoners’ reality, but are not accurate representations of the real world. The shadows represent the fragment of reality that we can normally perceive through our senses, while the objects under the sun represent the true forms of objects that we can only perceive through reason. Three higher levels exist: the natural sciences; mathematics, geometry, and deductive logic; and the theory of forms.

Socrates explains how the philosopher is like a prisoner who is freed from the cave and comes to understand that the shadows on the wall are actually not the direct source of the images seen. A philosopher aims to understand and perceive the higher levels of reality. However, the other inmates of the cave do not even desire to leave their prison, for they know no better life.^[1]