A letter from America

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8 October 2015 Est. reading: 14 min read

In his wonderful 1979 book, “The Old Patagonian Express – by train through the Americas”, Paul Theroux notes that you can tell a lot about the state of a country from the condition of its railway stations. As I marvel at the beautiful domed structure of Boston’s South Station, built in the great era of American rail infrastructure expansion, I’m inclined to agree. These days, the state of any country’s roads, airports and rail infrastructure reveals much about the priorities of contemporary society.

In short, if your airports, roads and railways are tatty there’s a good chance there’s not enough productive investment going on. These are litmus tests. If you doubt that, compare the sparkling Asian airports to our own dog-eared affairs in the English-speaking world.

I’ll put this theory – the Theroux rule – to the test soon as I am leaving America through the underwhelming portcullis that is JFK at the end of this train journey which takes me from Harvard in Boston, to Queens, via Penn Station in Manhattan.

Harvard Yard is privilege squared. It is everything America does best: massive amounts of private philanthropy fusing with generations of public investment to create the perfect seat of learning, attracting the best of academic and student talent, in an unrivalled environment.

Let the journey begin and let’s see if the Theroux rule still holds.

As I wait in the queue for tickets at the subway station (one of the machines is broken), I’m reading over the shoulder of the man in the Brookes Brothers suit and see that the Wall St Journal is praising the fact that the Fed didn’t raise rates or, in the parlance of Wall Street, didn’t move ‘off zero’.

With the next interest rate decision in mind, we’ll use this trip through the New England countryside to take stock of the US economy. Let me share with you my thoughts and observations from a short time spent in this affluent corner of God’s own country.

Boston’s old subway system has hardly changed since I washed dishes here as a migrant student way back in the 1980s. The Green Line out to Brookline still rattles away alternating above and below ground – a bit like London’s Northern Line with better views. The Red Line from Harvard is Boston’s equivalent of the Central Line – quicker than the rest, and therefore, jammed.

Moving from private Harvard to public transport, takes you from one world to another. Boston’s South Station echoes its splendid past and the plaque to governor Mike Dukakis reminds me of my time here when the so-called ‘Massachusetts Miracle’ was the envy of the US. Like most miracles, it proved to be nothing more than a large overdraft, fuelled by low interest rates, excessive bank lending and a property boom. Couldn’t happen again surely?

For now though, don’t worry about overvalued assets, just sit back, relax and enjoy the trip through leafy, yet nautical New England towards New York’s Penn Station.

The first thing you notice about American trains is that they are expensive, slow and crowded. At $159 one-way for a cramped seat and a journey that takes over four hours to travel just 200 miles – a Japanese bullet train it is not! However, the scenery is beautiful, the sky is Massachusetts Indian summer blue and we have plenty of time.

I am going to gather up my thoughts by way of seven points that explain where the US economy is now and may help us assess where policy goes from here.

1. Repaired balance sheets

The first thing to appreciate is that the American economy has gone through a remarkable healing process over the past few years. Its battered balance sheets have been nursed back to health.

The three balance sheets are now in much better shape. The government balance sheet looks impressive, particularly when compared to those of other western economies. Although debt ceiling issues continue to rankle, the budget deficit has fallen to $412bn and is now as low as it was before the financial crisis. For a $16 trillion economy with a so-called tax and spend President, this prudence deserves recognition.

The household balance sheet is also in decent shape, driven as it is in the main by house prices. The continued upward tick in home prices is doing wonders for the average American family.

On the face of it, corporate balance sheets are in rude health but the data is heavily influenced by the titans of corporate America. The niggle here is the extraordinary level of junk debt that has been issued by smaller but still substantial businesses in recent years, much of it used to buy back equity in order to flatter earnings and allow management teams to feather their beds with earnings-linked bonuses. More on that later…

Overall though, the healing of America’s balance sheet is well advanced. A combination of zero-bound interest rates, rapid and prolonged asset price inflation and that great healer of all ailments, time, appears to have done the trick. The country is on the verge of escaping the clutches of a vicious liquidity trap – the fact that it has done so using monetary policy alone, should be a cause for celebration. They said it couldn’t be done.

2. Rise in employment

The second factor has been the rapid and sustained rise in employment. The ‘animal spirits’ that characterise this society and which were hindered by broken balance sheets after the 2008 crash, have been released anew. Unemployment has fallen rapidly and jobs are being created in significant numbers, particularly in the domestic services sector, so much so that we are close enough to full employment or, at least, getting there.

As we move through southern Massachusetts, there are ads at each station promoting college courses, new housing developments and health insurance deals, all of which nicely capture the job-creating service sectors of 2015 America: education, health, housing and the broader financial sector.

The participation rate remains a cause for concern, however. Millions of workers have left the workforce completely over the last decade, disillusioned by the prospect of getting the job or the salary that they feel that they deserve. The US labour force participation rate hasn’t been this low since the late 1970s and this phenomenon poses more questions than it answers. Have these workers priced themselves out of work? There are jobs for burger-flippers and lawyers but what about the myriad of tiers in between? Are these people lost from the workforce forever? And what does this new labour force dynamic mean for the age-old relationship between labour market capacity and wage growth? Only time will tell but it is fair to suggest that the American labour market is in better shape than most.

3. Business investment

Despite the rehabilitation of balance sheets and the decline in unemployment, business investment is still on the canvas.

Half a decade of buoyant financial markets and explicit incentives that link corporate bosses’ wealth to their share price has led to corporate America buying back their own shares and paying themselves. So rather than investing in real productive capacity which we could term ‘productive engineering’, that which drives industrial productivity, corporate America has fixated on ‘financial engineering’, which usually only drives personal wealth.

Normally at this stage in a recovery, the economy would be registering big-ticket capital investments but this is not happening.

In 1979, the same year Paul Theroux started his epic train journey through the Americas, further along these train tracks towards Washington, Bruce Springsteen released “The River” with its tale of New Jersey’s industrial workers, steel men and blue collar Americana. These men worked in big, loud factories making American stuff for American people. Springsteen’s working class heroes were the human face of business investment. But they are not here now. America is not investing, it is disinvesting. Why is this? Is there anything else apart from share buy backs and financial jiggery pokery?

We are now pulling out of Providence, Rhode Island and moving towards the inflated property hot-spot of the hedge fund capital of the country, Connecticut. Nowhere in the country has benefited more from QE and zero-bound rates than this place. With its super mansions and long/short trades, Connecticut is buoyed up by the accounting trickery of share buybacks and the financial alchemy of QE, making it not only the richest part of America, but also – and this too is the consequence of QE – the most unequal.

4. The global capacity glut

Here’s where we have to leave leafy New England and go a bit global to understand the soft state of corporate America’s long-term expectations. If companies are confident, they will invest so why aren’t American companies confidently investing?

Sometimes visitors marvel at how insular the average American can be, for example, I was reading in the Boston Globe about the baseball ‘World Series’ league. The American baseball league has nothing worldly about it. It’s a glorified game of ’rounders’ that only the Cubans play properly and they are still embargoed.

But while the average Joe mightn’t have a passport, corporate America is hyper-global. Its worldwide footprint makes it highly sensitive to the global economy and the reluctance of America’s biggest companies to invest is a function of global conversations at board level.

Those conversations will start with the observation that America is on its own in terms of having a growing economy. There simply has not been a period in recent history where global growth rates are so divergent. Europe is still gripped by austerity, Japan hasn’t been right for a generation and the Chinese economy is facing a rapid post-boom contraction. Elsewhere, the big commodity-based emerging markets like Brazil, South Africa and Russia are simply derivatives of China as their wealth is largely a function of China’s demand for their raw materials.

So global aggregate demand is too soft to justify new large-scale investment. There isn’t enough aggregate demand in the rest of the world to make large corporations commit to investment. Remember that real investment tends to be in big machines that make big stuff.

This lack of demand is unfortunately coincident with a massive glut of supply. There’s over-capacity everywhere, particularly in China. Five years of hyper-investment in China has led to over-capacity in almost every major industry. How else can you explain slumping commodity prices and deflationary pressures everywhere?

Against such a background, can you imagine what would happen to the career prospects of an American steel executive who suggests to the CEO that they build a massive new plant to export steel to China?

Therefore, the short-term implication of the Chinese investment boom is far too much supply in the global economy. All the heavy equipment that the world needs is already in China and this will take quite a while to use up. Corporate America faces a global supply chain – not a national supply chain – too much capacity in China actually means too much capacity in America. As a result, it would be wrong to expect a material pick-up in large-scale US business investment.

5. Who takes up the slack?

And this leads us, as the train slowly passes the paper-profit Mecca of Rye, to the dilemma for America, which is that even with healthy balance sheets and something close to full employment, big-ticket investment needs to be encouraged in the US. If it is not, the US may indeed be stuck in the type of secular stagnation warned of by Larry Summers, the chief cook & bottle washer at Harvard, the place I have just left.

But given the global capacity glut, who will invest now and in what? The fact that this express train is averaging fifty miles an hour may be a clue! Before we explore who will or can do the investing, let’s examine what a lack of investment does to aggregate income and savings and let’s explore how a lack of business investment is at the root of the productivity and low-wage conundrum too.

While it is true that aggregate investment equals saving in an economy, it is not the case that investment equals saving all the time. Getting to the end position where investment equals savings is an intricate process, whereby investment creates savings because investment creates income. When investment increases, demand increases, driving up wages and income.

Ultimately, where do savings come from? Savings come from income, of course! Income is the font of savings. Without income you can’t possibly have savings and without investment you can’t raise income in any material way. So typically savings derive from income and not the other way around.

If the private sector won’t invest, then surely the public sector should? We’ve already identified that the American public sector balance sheet has capacity to expand productive investment. That’s what zero interest rates and a flat yield curve tell us. The demand for paper right now is undeniably vast!

Unfortunately for America, productive government investment to push the economy towards a higher income threshold – which would ultimately coax the private sector to invest too – is an anathema to today’s politicians, who are driven by ideology not economics. They don’t seem to understand one of the cornerstones of macroeconomics, that of the paradox of thrift. What is good for the individual is not always good for the collective.

The best way to visualize this is to turn on Fox News and watch the Republican Presidential debates, if you have the stomach. Witness the candidates falling over each other to promise less government investment and more fiscal tightening. Listen to the homespun stories about how their grandmothers balanced the weekly budget.

This belies a lack of understanding of the paradox of thrift, which helps to explain how the economy works. Your spending and investment is my income because you buy stuff from me. Then I buy stuff from the next guy, which gives him income and he spends, giving someone else income and so on. Each time there is a rise in income there is a rise in potential savings because there’s always someone who will choose to save rather than spend.

So if we all behave like our mythical grandmothers by saving, who will spend and invest? And if no one invests and spends, how will anyone have any income?

The US is stuck in the strange situation where it has the capacity for public infrastructure spending, it needs public infrastructure and yet it won’t spend. This sets off a vicious cycle where investment is low, therefore incomes are lower and ultimately savings are low. Without significant investment, it’s hard to have significant productivity gains and therefore real wages remain subdued.

As a result, the only factor underpinning consumer demand is the repaired balance sheet rather than increased income. To borrow a phrase from the economics textbook, we have solved the stock problem, but the flow problem remains.

6. Inflation war is over

Reading the Wall Street narrative, the story is that the Fed will move off zero because of some incipient inflationary threat. Despite the supply glut, widespread deflation, collapsed commodity prices and precious little upward pressure on wages, many economists continue to believe that inflation is just around the corner. How come? Where will it come from in the secularly stagnant world?

I take a different view.

As we pull gingerly into the ancient Penn Station, the reason the Fed wants to move off zero has nothing to do with a fear of inflation. It’s because it wants to signal victory over the liquidity trap. It has already defeated inflation. The old inflation battles of our youth are over. Unfortunately, too many central bankers and prominent economists are a product of their education in an age when inflation was the enemy. Today the enemy is ongoing deflation, not rekindled inflation.

Moving off zero for the Fed now is not about inflation – it is about equity and bubble risk.

7. Why should everyday folk subsidise the hedge fund manager?

I’m now on the Long Island Railway towards JFK. It’s hard to imagine that this is a distance of only twenty miles and it is scheduled to take about an hour. We are travelling at twenty miles an hour in the city that claims to be at the cutting edge! Take that in.

Not to worry, it gives us time to explore the societal results of the past few years’ policy of zero-bound rates.

One thing about suburban railways is that the type of person on them is very different to the people on the intercity trains. On the Amtrak to New York, the people are well-heeled, they choose the train over the cheaper and infinitely more frenetic flight. But on the ordinary train, there are loads of older people, young people and immigrants. Not many Brook Brothers suits here.

Let’s think about how the zero rate policy has affected these people like the Irish-looking granny sitting opposite me. She looks like my own late grandmother. I’m sure she’s Irish-American. Think about her and zero rates.

For the past few years we’ve had nominal interest rates at zero and inflation at around 2%. This means that this granny’s small savings are costing her money. She is getting a negative return. So the least risky saver is punished by zero rates. And who is the most risk-averse saver? The poorer people of course! So Granny’s’ income is penalised by the Fed as it tries to rebuild the national balance sheet.

But who benefits most?

Well, here is where it gets interesting. The zero rate is like an ‘at the money put option’ for risky assets. And who owns risky assets? The rich guys do. So we have a political problem, which comes from rates being at zero. It is a policy that rewards the most risky asset holders and punishes the most risk-averse saver. In fact, it’s a speculators’ charter.

And what happens when you underwrite risky assets? You get bubbles in asset prices. Now we don’t want to go back there, do we?

Time to go. My Aer Lingus flight is being called. The experience in JFK has been agricultural. In fact the entire public infrastructure experience in the US has been profoundly underwhelming. That’s the best argument for public infrastructure investment – and it would have the attendant positive of boosting income saving and giving some of the fruits of growth back to the everyday folk of America.

As I leave, it’s a matter of if not when, the Fed starts to hike. But with the shackles unlikely to be removed from American fiscal policy any time soon, the tightening of monetary policy is likely to be modest in scale but unambiguous in direction.

This policy change comes at a time when the storm clouds are gathering over much of the rest of the global economy, which explains the Fed’s reluctance to hike in September. America has been a beacon of economic strength in recent years but, when the time comes to move off zero, we’ll just have to hope that America’s creaking infrastructure can cope with the deflationary forces, and the conspicuous absence of demand elsewhere around the world.

David McWilliams (Twitter: @davidmcw) is one of Ireland’s leading economic commentators and was the first economist to identify the Irish boom as nothing more than a credit bubble, warning of its collapse and the consequences for the country. His objective is to make economics as widely available and easily understandable on as many platforms as possible. His daily market commentary www.globalmacro360.com is read by tens of thousands of his over 230,000 Twitter followers.

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