"Recession" Narratives

Following up from my recent WSJ op-ed with Andy Puzder, "Recession Fears Are Overblown" from two weeks ago (where we outline reasons why yield curve inversion may be a broken recession indicator [Fed balance sheet weighing on the long-end, T-bill issuance pushing up short-rates, and foreign pension demand amid negative yielding foreign debt] and why macroeconomic conditions continue to be strong [unemployment below 4%, GDP growth above 2%), here is an interesting graphic I put together which depicts the recent "recession" narrative: there has been a decline in Google search traffic for "recession" since the initial 10-year/2-year yield curve inversion on 08/14/2019 (when Google searches for "recession" spiked). Interestingly it very closely follows what a Kermack-McKendrick type model predicts:

Prediction market recession odds from PredictIt were also up at the time of the yield curve inversion as well and have remained somewhat anchored there. Betters were paying to receive a near 46% chance of a recession by 2020—which is above the 21% historical mean a recession occurs over any 1.5 year period implied by the historical 15% post-war average probability a recession happens in a given year. Those elevated prediction market recession probabilities have fallen slightly to around 40% (this also assumes prediction markets are unbiased estimators and don’t pay some hedging premium etc). It’s interesting to note how the simple breach of a single financial folktale rule-of-thumb, that being the 10s2s yield curve inversion, could alone be so influential in generating generate a massive media narrative surrounding recession that semi-permanently increases recession expectations (the 10-year minus 3-month yield curve first inverted back in March 2019–not to say that’s in any way a better indicator; our WSJ piece argues they are both broken). Interestingly, U.S.-based Google searches for "recession" spiked in 2008 ahead of the Great Recession. All very fitting given the upcoming release of Bob Shiller’s “Narrative Economics: How Stories Go Viral And Drive Major Economic Events” to be released October 1.

Public Debt In A Time of Growth (And Low Interest Rates)

If you attended the annual ASSA meetings this year, you may have watched or read Olivier Blanchard's American Economic Association presidential address entitled "Public Debt and Low Interest Rates".

Blanchard observes that for most of the post-war period, real GDP growth (g) has been higher than real interest rates (r). He further makes the point that if real growth is higher than real interest rates (r-g < 0), we can grow our way out of an existing debt stock with relative ease. Blanchard argues this is reason for us to be "less worried" about public debt and that debt is "less bad" than we think. There’s also some nice modelling using a Diamond OLG framework if you have the time to read all the way through.

It is true that there are only three ways to reduce public debt (other than default): 1) lowering fiscal deficits (G-T),  2) higher economic growth (g), and 3) seignorage (the latter of which we can and should ignore for inflationary reasons). While we often talk about #1 in fiscal policy/public debt discussions while #2 is either ignored or poorly quantified. Blanchard finally gives #2 the proper attention that it deserves.

Paul Krugman over at the NYT correctly observes and makes the related point that we didn't pay back the debt accumulated from WW2 (when debt-to-GDP was close to levels today around 100%) through taxes or spending cuts. Instead, the U.S. grew its way out through g, something that we we’re able to do in part because r-g < 0 for most of the 20^th century (I’ll add while debt-to-GDP levels remained below 100% with a clear path to paying our way out.

We can certainly grow our way out of the existing stock of debt no problem as Blanchard observes, but what if deficits (G-T) persistently grow at rates higher than r-g? In other words, is r-g scalable at higher levels of debt-to-GDP? r-g aren't exogenous and r and g both depend a lot on the growth rate of G-T.

Here is what the r-g differential looks like for the G7 countries at higher levels of debt-to-GDP:

It appears the "Blanchard effect" (where r < g and grow out debt) ends somewhere between 50 to 100% of GDP (depending on the country). The US, which has the world's reserve currency, appears to be something of an exception which might be at the higher end of that range. 

What is causing the Blanchard effect to diminish as debt-to-GDP gets closer to 100%? More or less, it's the same story of Reinhart-Rogoff's "Growth In A Time of Debt" observation that growth begins declines non-linearly with GDP hitting a flashpoint somewhere around 100%:

The real interest rate however is largely invariant to Debt-to-GDP (historically real interest rates haven't changed much over the past 700 years):

Of course, if some event suddenly shifts expectations negatively toward an increased likelihood toward non-repayment of public debt, this sends r skyrocketing (the G7 examples exclude default cases like Greece and Argentina of the world, which hit default at very different levels of Debt-to-GDP).

Absent any shocks to default expectations, the “Blanchard effect” predicated on r-g seems like a real phenomenon to be taken seriously in lower. There could be other reasons behind the historical post-war r-g < 0 phenomenon such as the high productivity of the 20^th century which may not continue into the 21^st century indefinitely per Bob Gordon’s arguments.

That's not to say, that higher levels of debt-to-GDP couldn't be sustainable (or that there wouldn't be good reasons like increased investments in public education), just that this offsetting "Blanchard" effect which is a feature of the "specialness" of government debt that disappears at a certain point (between 50 and 100% of GDP) and shouldn't be a point of justification for additional debt increases.

Cyptomania and the Bitcoin Bubble

Bitcoin is a bubble.

While that may seem like a trivial statement to bitcoin skeptics and heretical to bitcoin enthusiasts, bitcoin is one of the most incredible phenomenon in recent memory.

As a University of Chicago undergraduate, I was almost constantly reminded that there was no rigorous definition on an asset price bubble, however I would define them as a transitory surge in asset prices fueled by incomplete/poor information, risk seeking behavior and fear of mission out.

History provides countless examples of assets for which there have been incomplete information or misinformation from the tulip bubble of the 1700s to the dot-com bubble of the 1990s.

Few sophisticated Wall Street firms have even considered trading in bitcoin, and for a good reason.

There are 3 components to a currency: 1) being a medium of exchange, 2) being a store of value, 3) being a unit of account. Bitcoin and cryptocurrencies certainly fail at #1) as extremely few vendors will exchange goods for bitcoin, let alone know what it is. They also don't do well at #2) with providing a stable store of value given the huge amount of daily volatility bitcoin and other cryptocurrencies have.

Some of the popular arguments given by crypto enthusiasts to justify their price include: one a fixed supply which should cause prices to rise over time as the demand and uses for a cryptocurrency increase over time. However, with more crypto currencies popping up almost every few days in "ICOs", we now have a rapidly expanding supply of cryptocurrency with the rise of Ethereum, Litecoin, Bitcoin Cash, Dogecoin and the list goes on.

The other argument is that the cryptocurrency accounting mechanism of blockchain technology is such a technological breakthrough that it can somehow sustain price increases. Blockchain is indeed a revolutionary technology but it will continue to grow just as easily without being married to bitcoin and cryptocurrencies (Ripple being a great example using cryptocurrency to revolutionize payments)

What is consistent with almost every major asset price bubble is how poorly an asset is understood among its often unsophisticated buyers.

The amount of unsophisticated bitcoin investors (of a size of roughly 16.3 million currently in the U.S. according to estimates) who don't understand the technology behind bitcoin are numerous. Libertarians have played a substantial role in the movement promoting the belief that somehow bitcoin will replace traditional sovereign backed currencies as we enter some sort of anarcho-capitalist utopia they envision.

Surprisingly, there have been reports that over the past 3 weeks, the most popular topic in NFL locker rooms has been Bitcoin. It shouldn't be surprising that NFL players are statistically more likely to go bankrupt than other individuals because of their poor spending and saving habits couple with their irrational expectations about the length of their NFL careers potentially lasting a decade (which is only about 3 years on average).

The frenzy has become crazier, with companies like LongFin, Riot Blockchain, Crytocurrency AG all seeing huge surges in their stock prices, and most hilariously Long Island Ice Tea Company witnessing a 500% appreciation in its stock price after simply changing its name to "Long Blockchain". Some of these companies the SEC has even begun suspending trading in and lawsuits alleging fraud against various crypto ICOs have began emerging.

Ultimately, the cryptocurrency market has become a "Keynesian beauty contest". In other words, people are not even placing value on what they truly believe bitcoin or other cryptocurrencies are worth but more importantly what they think others believe they are worth based on the vague promise of a revolutionary technology and bitcoin's price rise becomes a self-fulfilling prophecy.

Its only a matter of time before people realize that cryptos are worth closer to $0 than their current valuations.