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The blog post aims to describe the emergence of instability in a stable economic structure. Specifically, the onset of financial instability due to the capital structure decisions by microeconomic agents increases the sensitivity of the system to endogenous and exogenous volatility or disturbances. The micro is connected to the macro systematically, and the inter-dependence is one of the main reasons for the classic boom and bust cycle.
Investors, corporate managers, and households keep reciting that the macro doesn't matter and make decisions irrespective of the financial structure. Still, the blog post will describe how their negation of macro-economic structures builds the poor economic structure in the economy and how their paranoia during volatile times causes the system to breakdown.
The blog post will also describe how, in the long-run, policymakers, economists, and market participants produce disequilibrium into the system, which aggregates and leads to a period of high inflation, or high unemployment, or debt deflation, or depression. The main reason why our economy behaves in different ways at different times is that the financial practices and the structure of financial commitments change.
It is not the trade war, government intervention, political changes, geopolitical tensions, or monetary intervention that causes the financial crises. They surely are the catalyst, but the structure of the economic system determines the robustness of the system against these shocks.
The blog post's thesis is inspired from Minsky's hypothesis - Stability is Destabilizing. The blog post takes the perspective of the US economy. All opinions are my own.
Capital Structure of the Firm
The investors and corporate managers make asset-liability and valuation decision based on the following understanding of the firms:
At any particular time, the corporation makes money by the following way:
1. Internal cash-flow generation from the investments and assets.
2. Asset Sales. 3. External funding: issuing debt or issuing equity.
Based on the nature of business and liability structure, they have the following payment commitments:
1. Cost of Production
2. Overhead costs
3. Labor costs
4. Financing costs
Corporations are categorized into three types:
1. Hedged firms - They can generate cash flows needed for contractual payments and has a relatively sound liability structure.
2. Speculative firms - They can generate cash flows required for contractual payments but would need refinancing in the future to remain going concern. 3. Ponzi Schemes - They require refinancing to meet the current contractual payments, and the rolling over of debt or issuance of equity is needed to remain going concern.
There are two types of capital assets:
1. Debt
2. Equity
The cost of debt is decided by:
1. Risk free rate - that is short-term interest rates by the central bank.
2. Credit risk premium - determined by the bankers and credit investors based on their expectations about the future cash flows for salvaging their capital investment.
The cost of equity is decided by:
1. Risk free rate - determined by the central bank.
2. Equity risk premium - decided by the financial conditions which is determined by expectations of the future cash flows and equity investor's confidence.
The cost of capital is dependent on the capital structure and the cost of debt and equity. The decision to invest and to acquire capital assets is always a decision about a liability structure. The stability of the economy depends upon the way investment in capital assets is financed.
The Margin of Safety is defined as the difference between the return on the capital - (minus) cost of capital. The robustness of the fragility of the financial system depends upon the size and strength of the margin of safety & the likelihood that initial disturbances are amplified.
The amplification of disturbances into the system is dependent on the distribution of entities by hedge entities, speculative entities, and Ponzi-scheme entities in the economy. In other words, if there are more speculative firms than hedged firms, then the system will be very fragile to external shocks. To sum it up, instability is determined within the system, not outside.
"Stability is Destabilizing"
During stable times, capital assets are cheap and straightforward. The equity risk premium and credit risk premium are meager. Corporations invest, and they can generate an excess return over the cost of capital. The investor confidence rises, and the stock market goes up, which lowers the debt to equity ratio of the firms. It leads to lessening of credit risk premium, and the loop feeds itself, creating a self-fulfilling favorable financial condition.
Instability exacerbates as production becomes more capital intensive, and relative cost & gestation period of investment increases, for in such, capital markets' financing conditions are likely to appear in which rolling over debt increases. There is always a new financial innovation in the capital markets, reducing the cost of capital of the firms. The process is called financial engineering. So, the margin of safety is pumped up by the market participants, and any capital structure of the firm seems reasonable at that point.
During the times of stress, the margin of safety collapses at a rapid pace, and firms that were speculative or participating in Ponzi-schemes require cash payments to capital owners. There are two post-stress situations:
1. Liquidity crises: Fire sale of production assets or capital assets reduces the market value of the assets, and there is a massive liquidity crunch. 2. Solvency Crises: They are unable to make the payments, and the firms go bankrupt.
During the liquidity crunch, government or monetary policymakers try to intervene to restore the faith in the system and provide liquidity or bailout funds to essential entities. The efficacy of the politicians is dependent on their diagnosis of the market crunch and their capacity to provide relief funds and monetary adjustments. If it is an open economy, that is, the foreign consumer/corporations/government impacts the country, then transmissions of shocks would look like this:
Source: The Volatility Machine
The external shocks not only impact speculative or Ponzi schemes, but the spillover also affects hedged entities. The expectations of cash flow decrease, leading to an increase in equity and credit risk premiums. The past valuation doesn't make sense at that moment, and the assessment of hedged entities falls.
Also, it impacts their fundamental underlying cash flows because it affects their customers, such as consumers, government, and foreign players. It changes them because workers in speculative and Ponzi schemes are laid off, which reduces total consumption in the system. The hedged entities reduce wages or lay off workers to keep their profitability justifiable to capital owners. Also, the bailout funds reduce government capability to spend in the future. At this moment, the only way is down. The crises lead to chronic inflation or debt deflation. The existing financial and economic structure determines the outcome.
The description of the classic boom and bust cycle for any capital asset is in one of my blog post: Fallibility, Reflexivity and the Financial Markets.
The Relation between Underlying Cash Flows, Wages, Capital Assets, Government Spending and External Shocks
The underlying cash flows of any firm depends on revenue and the cost of running the business. The sales depend on the output and price, while the costs are of the following types: commodity costs, labor costs, fixed costs (machines, plants), variable expenses (marketing, utility costs, etc.), and financing costs.
A. Revenue Drivers
Revenue = Price * Output
Consumer price is a variable item that is dependent on the structure of wages, productivity, commodity prices, and external shocks.
Demand for Output is dependent on the product-market mix. For example, A firm is selling product 1 to market X. The market could be an industry, geographical location, or a demographic, etc.
A.1 Growth Drivers
The revenue growth from production (output) is through the following ways:
1. Organic Growth: Creating a new product in the existing market or selling current products in a new market. 2. Market Share Performance: Increasing market share by serving quality products at sound profitability or reducing prices by compromising profitability. 3. In-organic growth: Acquiring other firms for increasing market share or acquiring nuclear capabilities.
The financing and liability structure of the firm or investment is essential for sustaining growth or maintaining growth.
A.2 Price Drivers
Prices are dependent directly on wages of the consumers & commodity prices; and inversely proportional to the productivity of the producers. If wages are low and productivity is high, then the prices would be in secular deflation. The moves in commodity prices would determine the cyclical changes, but the trend would be downward. It is what is happening in the current economy. If the wages are high and productivity is low, then the prices would be inflationary. It was relevant in the 1970s. Hence, due to this specific economic structure in 1970, the oil shock produced chronic inflation.
The structure of wages to GNP and productivity impacts the prices. In conclusion, the commodity prices, the external shocks, and the prevalent architecture of the economics would determine prices in the economy.
A.3 System Revenue Drivers
On an aggregate basis (macro-perspective), revenue is dependent on total consumption. The total expenditure categorized into the following types:
1. Consumer Spending: Spending from the wages (for workers) and capital gains (for capital owners). The structure of the distribution of spending between workers and capital owners affects consumer spending, as well as the decision by workers and capital owners to spend or save impacts consumer spending.
2. Government Spending: Spending by the government. The government income is dependent on taxes on wages, corporation's profitability, and capital gains. If the taxes are not sufficient enough because of policy decisions or the ability to tax or lower wages/profitability/capital gains, then the deficit is funded by selling government assets or taking more debt. So, government spending is also dependent on the liability structure of the government, the same way as corporations.
3. Foreign Consumer Spending: Spending by foreign consumers. Determined by comparative advantage of a country and trade-finance.
Total System Revenue = Consumption out of Wages + Consumption out of Capital Gains + Government Consumption + Foreign Consumption
A.4 The Paradox of Revenue Growth in a Deflationary Environment
Here is the Paradox:
If wages as % of GNP reduces, then government taxes as % of GNP will also decrease if the tax rate remains the same. It will compress total revenue in the system.
If there are high savings out of wages and savings out of capital gains, then the total consumption will compress further.
If the foreign consumption is detrimental, meaning international firms are extracting revenue from the system (say US total revenue), then revenue of US firms will depress further in the US.
The only way for revenue to grow organically would be through government spending funded by debt or consumer spending using debt, too. If, in such a structure, a firm is growing market share through price competition or higher productivity, the wages and prices will compress further. The economy will be in a deep deflationary environment, and the debt burden will rise each quarter. According to my analysis, this is what is happening in the current economy. I have empirically described the structure of the current economy in the blog post: The Global Economy: Capitalism and Schizophrenia.
B. Types of Profit
B.1. There are two types of profit:
1. Non-Capitalist Profits: When the production is free of capital assets such as debt or equity, then all the profits are distributed among the cost of production, wages, and investments. It is usually true when the government or not-for-profit organization controls the output.
Non-Capitalist Profits = Total Revenue - Total Costs = Investments
2. Capitalist profits: In the case of production funded by capital assets such as debt or equity, the realized gains will be higher than 'Non-Capitalist Profits.' The excess profits are used to pay back capital asset owners: interest/principal payment to debt holders and dividends to equity holders. They are also used to validate the market prices of capital assets. For example, if the market value > sum of [tangible book value and intangible book value] , then the current profits or expectations of profit will be higher than earnings in a non-capitalist economy.
Capitalist Profits = [Total Revenue - Total Costs] + Excess Profits = Investments + Excess Profits
B.2 Excess profits are good because of the following reasons:
1. 1. Funding Investments: In a private economy, investments will have to be funded by borrowing or through cash equity. Excess profits will be used to pay back the lenders. It helps when the corporation's investment needs are more significant than its present internal cash flows, and the expected profits will be higher than the cost of borrowing.
2. Motivating Capital Owners: Receiving a higher return on their investments is usually the sole motivation for capital providers. Excess profits will be used as a reward for risk-taking, as well as; they will be motivated to allocate capital to productive and efficient assets.
B.3 Excess profits + Greed leads to failure of the system due to the following reasons:
1. Replacing Jobs not Workers
Capitalist Profits = [Total Revenue - Total Costs] + Excess Profits
The first component of Capitalist Profits is [Total Revenue - Total Costs]. When capital owners decide to compress wages to be profitable in the short run, then the overall system will start becoming unstable. Sooner than later, total revenue in the order will squeeze. In such a case, excess profits will lead to an increase in household debt, unemployment, or deflation.
While, in a stable economy, improving the productivity of labor and production will be the sole reason for increase in profitability.
2. Capitalism without Investments
Capitalist Profits = [Total Revenue - Total Costs] + Excess Profits = Investments + Excess Profits
When the production profits are not used for investments, but for excess earnings in the form of returning capital or piling cash, then the system will become unstable. It is because it reduces potential profits in the future. The system is not build to last.
B.4 "The Myth of Capitalism: Monopolies and the Death of Competition"
Competition in the economy makes sure that the corporations do not compress workers' wages or not replace them to increase profitability. The productivity stays robust in the system as competition keeps forcing companies to invest in productive assets. It also encourages more investments than capital buyback or piling off cash. Unfortunately, that is not the case & the disequilibria are aggregating. You could refer to the blog post: The Global Economy: Capitalism and Schizophrenia for more details.
C. Profits and Capital Assets
Total Profits in the System = [Total System Revenue - Total Costs] + Total Excess Profits
or, Total Profits in the System = Total Investments + Total Excess Profits
Total System Revenue = Consumption out of Wages + Consumption out of Capital Gains + Government Consumption + Foreign Consumption
So,
Total Expected Excess Profits (Growth Assets)+ Total Market Value of Assets = Total Debt + Total Market Value of Equity
In summary, profits are dependent on:
1. Consumption out of wages.
2. Consumption out of capital gains or wealth.
3. Government Spending from tax revenue
4. Foreign demand
5. Commodity costs
6. Productivity
7. Investments
8. Consumer debt
9. Government debt
10. Excess profits
11. Competition
Capital Assets, which are equal to the sum of total debt and total equity & is dependent on:
1. Profits
2. Current real assets
3. Growth assets i.e. expected excess profits.
4. Demand for capital assets i.e. savings
The overall structure of economics is dependent on these values. The fragility of the system is dependent on the distortions of these values or significant imbalances caused by market activity. If the order is unstable, then externals shocks to the system will cause extreme volatility. Sometimes these shocks will cause liquidity traps, and other times, it would lead to chronic inflation, debt deflation, high unemployment, or depression.
My Take on The Current Structure
1. Capital assets are high to profitability. The corporate indebtedness is high and as well as, expectations of future cash flows are high.
2. Profitability is high to wages as well as government spending from taxes. We are in a deflationary environment with low revenue potential.
3. Due to that, deleveraging of corporate debt is highly related to the increase in the sum of [government debt + household debt].
4. An increase in government debt could be used to keep corporate profitability elevated. I call this phenomenon as managing the bubble. The sustainability of the management of the balloon will depend on government policies, as well as external shocks.
5. Government debt could also be used to increase labor productivity, and hence, rising wages. It will be suitable for the long term, as the government will spend less in the future and collect more taxes from increased wages. It is what happened between 1938 and 1945 because of the Keynesian revolution. Check out the related blog post: The Zeitgeist of Today & The Pendulum between Market and Government I.
6. In the system, the total revenue is growing less and, the needs for excess profits and expected cash flows to keep asset prices elevated are increasing.
7. It is just a matter of time when the left-hand side of the equation will not be sustainable with the demand from the right side of the equation
Total Expected Excess Profits (Growth Assets)+ Total Market Value of Assets = Total Debt + Total Market Value of Equity
8. In other words, the imbalances are very high in the system. Check out my post: The Global Economy: Capitalism and Schizophrenia, for more details.
9. At best, we are most probably in a meta-stable state.
10. I would be monitoring the 2020 US elections very closely.
11. Nevertheless, the time is against the system.
