Kalecki's End of the Business Cycle and Bond Wars

This article was first published by me on Talkmarkets: https://talkmarkets.com/content/bonds/kaleckis-end-of-the-business-cycle-bond-wars?post=165494&uid=4798

Michal Kalecki was a distinguished Polish economist who discovered insights into functioning of capitalism and the business cycle. He understood that full employment was anathema to the capitalist system, and that allowing a certain level of unemployment was key to preservation of the capitalist class. This is, of course, why I have warned that the greatest job of the Fed is to prune wages, and slow the economy as full employment approaches.

From Kalecki's point of view, capitalists want to limit government spending except for armaments, which benefit the class. Recent tax cuts have shown that the Republicans, especially, have bloated armament spending while destabilizing the stock and bond markets with volatility, and with tax breaks that cannot easily be paid back. This instability could hasten the demise of the current business cycle. More on the bond wars at the end of this article.

Professor Kalecki contributed many ideas to the field of economics, but certainly the concept of investment as being the cause of savings for the capitalist class was central to his thinking. Of course, modifications have been made to his first equations, as workers now save some money, have 401k's and access to stocks and bonds, in a greater degree than in the past. But his conclusions are still very important, especially regarding business investment and the end of the business cycle.

A Portrait of Michal Kalecki by Manuel García Jódar

For the Polish economist, investment drove the business cycle. Lower investment meant an end to the business cycle. Without investment, there are no savings. Of course, the power of big business in more modern times has also caused that concept to be modified.

For example, Marc Chandler points out that the trade gap is widening. Exports are up, but not as much as imports. And this may be caused by firms that simply do not want to invest in the means of production. Marc, who is a frequent contributor to Talkmarkets, says about the McKinsey Global Institute (MGI )Report:

The report noted that only 1% of US companies export, making a shallow base. Moreover, MGI argued that the US manufacturing sector has been starved for investment. Private sector investment in US manufacturing was estimated to be near 30-year lows. The average age of US factories is 25 years, while average age of equipment is around nine years. 
MGI argued that it would cost $115 bln a year for a decade to fix the situation... However, companies did not lack for resources and the price and access to capital did not seem to be the main obstacle in the first place. 

It appears that since business already has plenty of cash and had access to easy credit, that investment is lagging and will continue to lag just because companies don't want to invest. It appears that commercial real estate is overbuilt. And in manufacturing, upgrades would mean that there would be more automation and workers could be hurt further. I know from talking to temp agency personnel, that some parts are being manufactured in the USA with low wages attached in order to keep the work in the US.

Raising wages or building better plants is not an option for companies competing against Mexico. Yet, cheap goods from Mexico, cars we can afford, etc, cannot be cut off without severe dislocation in the American economy. Our mini boom is driven, to Trump's chagrin, by imports! And yet, there is no guarantee that the world will jump to buy additional US exports.

Kalecki would have no doubt found the existing US economy to be perplexing, and complex. It is a lot simpler to make mathematical calculations when international trade is not a large part of an economy. Under the present reality, wages cannot go up by much.

Recently, as Mish Shedlock has said, wages that finally went up in the last jobs report have only gone up for management. Kalecki made the distinction between management salaries and wages of workers in his assessment as to the health of the economy.

Kalecki believed that investment finances itself, meaning growth resulting from investment increases profits and savings. Kalecki believed that you could see where we are in the business cycle by the level of investment made. Investment in some sectors is strong, but costs are elevated. Manufacturing investment is clearly lagging, per Marc Chandler.

Manufacturing investment decline coupled with a commercial real estate bubble that could constrain retail investment are a double dose of potentially bad news. It could be that
 the business cycle's days are numbered.

If that is where we are in this business cycle journey, and the commercial real estate bubble spoken of by Janet Yellen is just one possible sign, then the end of the business cycle could become a serious problem for both the economy and stock market, and soon.

We have seen that stocks often crash because of misplaced leverage, and people have to sell to cover positions that they have made. If they bet against inflation, or even against volatility, they may fear that those leveraged bets are dangerous. This may be irrational fear, or they may detect some potential inflation, and there certainly is some volatility.

It is clear that investors, with the major 1st quarter 2018 crash, are jittery about the potential end of the business cycle, with potentially higher interest rates tamping down wages and interest rates. There is massive leverage in the system, with a lot of new collateral on the line in clearing houses, that is subject to margin call as rates rise. Liquidity becomes a worldwide issue.

Kalecki's slowing investment concept will signal the final end of the cycle, especially if it affects multiple nations. Capacity utilization has recently spiked in the world, and that could put pressure on prices, especially with no new manufacturing investment coming on board.

The bond market likes lower capacity utilization:

It is often believed that when utilization rises above somewhere between 82% and 85%, price inflation will increase. Excess capacity means that insufficient demand exists to warrant expansion of output.
All else constant, the lower capacity utilization falls (relative to the trend capacity utilization rate), the better the bond market likes it. Bondholders view strong capacity utilization (above the trend rate) as a leading indicator of higher inflation. Higher inflation—or the expectation of higher inflation—decreases bond prices, often prompting a higher yield to compensate for the higher expected rate of inflation.

But how collateral demands in the new normal interact with this historic behavior of bonds to capacity utilization is not clear going forward and could pose a risk to traditional investment predictions. Trump has sought to flood the bond market with new bonds, attempting to destroy the New Normal, to destroy the conundrum, bond shortages, and low rates.

But will that reality of higher rates come to pass without establishing systemic risk and a threat of another Great Recession, or worse? If rates go high enough, will people flood into bonds, creating a new New Normal?

In the New Normal, bonds were gold. If they no longer are to be considered gold, with a flooding of supply, then the future could be turbulent without a suitable replacement store of wealth.

For Further Reading:

The Scariest Chart for the Market


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