Monday, November 21, 2016

Recession watch: Attribution error and inadvertent self-flagellation as policy and social norm

Here is a scary looking graph.  (HT: NickatFP)

Leverage is out of control, apparently.  We need some macro-prudential oversight, it seems.  This is a pretty common worry, and the comments at the link, as of now, are pretty common too.

"well rates are so low why would you not?"

"This is not going to end well."

Even the apologists seem to accept the premise.

"doesn't seem too worrisome, optimal capital structure altered by rate enviro. Not overly leveraged, could raise equity if need b"

Even though we've been hearing for years now that corporations are using low interest rates to leverage up, nobody seems to notice that leverage, according to this measure, has been very low for years while rates have been low.  Attribution error and confirmation bias are strong enough not to notice that this graph tells an improbable tale of corporations suddenly increasing their debt levels by 50% over just a few months after being very tepidly leveraged for a decade.

It is true that huge spikes in leverage appear to presage contractions.  On that I can agree that this chart is useful.  If we take a deep breath, though, what we see is a relatively flat level of leverage through the 1980s.  Then, at the onset of the 1990 recession, leverage shot up.  It moved back down to that typical level of about 1.2x EBITDA until it shot up again during the internet boom, with a second spike in the 2001 recession.

After that, leverage fell to practically half the 1980s levels, after which it moved back to about 0.9x.  Then it spiked again during the 2008 recession.  Then it dropped again, first to about 0.8x, then recovering to about 1.0x, before the recent spike to 1.6x.

What's going on here?  What's going on is that debt levels are a pretty boring, stable factor, but profits are volatile and dependent on nominal national income levels.

What we are seeing here aren't surges of debt.  We are seeing collapses in profit.

The first graph here compares corporate debt ("credit market instruments") to corporate equity values.  The second graph compares corporate debt to corporate profit.

In every case where leverage surged, it was falling profit that was causing it.  What causes profit to fall sharply?  This is almost entirely a monetary phenomenon.  Other factors, like debt levels and income shares, tend to evolve at a glacial pace.

So, every time nominal incomes start to disappoint, the first incomes to be affected are profits.  And, when this causes leverage to rise, the broad response is, "Oh, look.  Corporations are taking on too much risk.  This is going to be bad.  We better pull back the reins before they go any farther."

Is it possible to find a middle ground, where we counter softness in corporate profit without leading to high inflation, like in the 1970s?  I don't know.  What I do know is that what we are doing is a misidentification and a mistake.  The question here shouldn't be, "How hard do we pull back?"  The question should be, "How much can we accommodate before we risk inflation?"

The questions that guide policy now aren't even pointing in the right direction.  This was catastrophic in 2006-2008.

This is one of the advantages of NGDP level targeting.  It naturally pulls us in the right direction.  Not because it is some brilliant and difficult targeting scheme, but because it keeps us from doing so much damage.  It's like investing with passive rebalancing.  Literally doing nothing is better than what you would have done if you were trying to pay attention.  There isn't anything incredible about passive investing.  It effectively trades you a bottle of water for the Molotov cocktail you were reaching for.  If that is a benefit to us regarding our own hard-earned money, imagine how much we need it regarding our public positions about what other people are doing with their money.


  1. Well my poms-poms have been worn to a fray, but this is another great post. I'll shake the stubs in the air.

  2. Is it possible to find a middle ground, where we counter softness in corporate profit without leading to high inflation, like in the 1970s? --Erdmann.

    I wonder if this question, or the fear this question addresses, is the reason why monetary policy has been so tight.

    I wonder if the 1970s were an aberration. Ossified retailing, much larger unions, limited global trade, heavy regulations on transportation, communications, finance. Very high top tax rates. Limited capital and two oil spikes, and when I say spikes, I mean it. Oil went from $4 to $40, and we used a lot of it per GDP unit.

    Today, I think we should push the envelope and see how much monetary stimulus we can "get away with."

    Life has risks. Not every tin-pot loony is the next Hitler. The 1970s is not lurking around every bend, let alone the Weimar Republic.

    1. Good question. I think you might be on to something.