Still stuck in the Jackson Hole
It is profits that matter and investment that decides, writes Michael Roberts
Every August, the central bankers of the world meet at Jackson Hole, Wyoming, amid the Grand Teton mountains in mid-west America, to discuss the state of the world economy and the role of monetary policy and central banks. The central bank chiefs hear papers presented by leading mainstream economists in a restful weekend symposium hosted by the Kansas City Fed.1 Usually, it is an opportunity for the head of the US Federal Reserve, the hegemonic central bank, to make a speech outlining what is happening in the US economy and future monetary policy (and its efficacy).
This year it was the turn of Janet Yellen, the current Fed chief. Global investors and financial market participants always await expectantly to see what the Fed is thinking. The immediate issue for markets is whether the Federal Reserve will resume its plan to raise its ‘policy’ interest rate towards a ‘normal’ level. The Fed policy rate is the floor for all other rates - like bank loan rates for households and companies and also for international rates - given the predominant position of Wall Street in global finance.
The Fed under Janet Yellen hiked its policy rate back in December 2015 for the first time in nine years, supposedly as the start of the move back to ‘normal’ - on the grounds that the US economy was fast recovering back to trend economic growth and full employment. Yellen explained that it is “on a path of sustainable improvement” and “we are confident in the US economy”.2 But since December, the Fed has sat on its hands.
Why? Well, the return to trend growth has not materialised and inflation has not risen. In the first half of 2016, the US economy has expanded in real terms (after inflation) at less than 1%, a mere one-third of the ‘normal’ rate. The economy has been slowing down, not accelerating, while at the same time inflation fell back too.
So the Fed paused on its ‘normalisation’ policy. Indeed, there was talk of opting for cutting the policy rate and even introducing ‘negative’ interest rates. However, the Fed’s chiefs remained optimistic. Just before the Jackson Hole symposium, Fed vice-chair Stanley Fischer made a speech in which he reckoned that “the economy has returned to near full employment in a relatively short time after the great recession, given the historical experience following a financial crisis”.3
Now in Yellen’s Jackson Hole speech she reiterated her confidence in the sustainability of the US economic ‘recovery’ and hinted that the Fed would soon resume its hiking of the policy rate. She said:
In light of the continued solid performance of the labour market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months. Of course, our decisions always depend on the degree to which incoming data continues to confirm the committee’s outlook.
Yellen added that the US economy was “now nearing the Federal Reserve’s statutory goals of maximum employment and price stability”.
Central bank ‘conventional’ measures before the global financial crash boiled down to manipulating the basic interest rate for borrowing or providing cash or credit for limited periods to tide banks over in a slump. But, such was the depth and width of the impact of the global financial crash and great recession on the banks and the wider economy, central banks had gradually adopted more ‘unconventional’ measures, such as printing money to buy government and corporate bonds from banks at high prices to provide liquidity for the banks to lend on to ‘real’ economy; and offering ‘forward guidance’4 to the markets and industry: ie, a commitment to keep interest rates as low as possible for as long as possible, so that ‘confidence’ in investing was restored. The European Central Bank’s version of this ‘forward guidance’ was for president Mario Draghi to announce that the ECB would “do what it takes” to get the euro zone economy moving.5
However, as the world economy continued to crawl along - with GDP growth stuck, unemployment falling back very slowly and many economies slipping into outright deflation (bad news for those with big debts) - it was clear that monetary policy, conventional or unconventional, had failed. In the last year, many have called for more radical measures and some central banks have adopted them6: namely, ‘negative interest rates’ (Sweden, Switzerland, Japan)7 and even consideration of ‘helicopter money’ (straight cash handouts to households); or the abolition of paper money, so that all money is kept in banks electronically to be spent (and not stuffed under mattresses). This last proposal is the ultimate in bank dictatorship over people’s rights to their cash savings.
Just before Yellen’s speech, San Francisco Fed chief John Williams had suggested setting higher inflation or ‘nominal’ GDP growth targets8 (so that central banks print even more money). And it is interesting that all the papers presented to the Jackson Hole symposium by various mainstream academic economists had one basic theme: existing monetary policy is not working and we need to consider more unconventional and extreme measures.9
The economic strategists of capital are worried that monetary policy is not getting the world economy (and the US economy) out of its ‘secular stagnation’. The failure of current monetary policy pushes the monetarists like former Fed chief Ben Bernanke into proposing yet more of the same (cutting rates), combined with more of ‘not the same’ (helicopter money).10
Yellen was vaguely sympathetic to Williams’ idea, but, on balance, argued that nothing else was needed. And anyway, relying too heavily on these non-traditional tools could have “unintended consequences”11, as it might encourage “excessive risk-taking” and undermine financial stability. She argued that the Fed would not need to adopt any new measures of ‘unconventional’ monetary policy beyond those adopted since the onset of the great recession in 2008. Indeed, these measures could actually make the economic and financial situation worse: “Monetary policy is not well equipped to address long-term issues like the slowdown in productivity growth,” said Fed vice-chair Stanley Fischer.
The alternative policy answer of the Keynesians like Paul Krugman, Larry Summers12and Yellen herself is to call for government infrastructure spending and other efforts to counter weak growth, sagging productivity improvements and lagging business investment. You see, the problem is that the capitalist sector is not investing sufficiently to get productivity of labour growing faster and thus achieve real GDP growth.
As a share of GDP, US annual business investment since 2008 has averaged nearly a full percentage point below the previous decade.13 This has generated an investment shortfall equivalent to $1trillion, taking into account what it would have been if the previous trend had continued. Little suggests a rebound any time soon. Fixed business investment has fallen in three successive quarters as a share of GDP. And it is not as if the evidence is not there that the US (and UK) economies need to invest in new infrastructure and technology to lower costs and improve efficiency. The American Society of Civil Engineers has all we need to know.14
But would government investment compensate? In most major capitalist economies, business investment to GDP is about 13%-15%, while government investment is about 1%-3% - or about seven times smaller. If business investment slips by 1%-2% of GDP, then government investment would have to nearly double in GDP terms to just stand still. And that assumes that governments controlled by big business and big finance would contemplate a doubling of government investment that involves large increases in taxation or rising interest rates for borrowing (in other words, encroaching on profitability)15.
As I have argued, what matters in a capitalist economy is the profitability of capital and the mass of profits generated by the workers employed. If the profitability of capital is too low and the capitalist sector remains dominant, investment and economic growth will not recover, whatever central banks do and irrespective of government spending.
Indeed, there is yet more evidence from the Federal Reserve’s own economists that this is correct. In a recent study, two Fed economists, after consulting chief financial officers of major corporations, found the corporate internal rate of return needed to justify capital projects has “hovered near 15% for decades” and barely budged, even as global interest rates have fallen. So, even if interest rates stay near zero or go negative or if helicopter money is handed out, it will not make any difference if companies do not think they can get their 15%.16
It is no accident that Marxist studies of the US corporate rate of profit in the productive sectors (ie, non-financial) since the 1980s confirm an average rate of about 15%.17 US companies now expect 15%, but cannot get it. So they buy back their own shares or increase dividends instead on investing in new technology, plant or equipment.
So yet again it is profitability of capital that matters for investment and growth. Yellen and Fischer cite higher employment and consumption as reasons for hiking interest rates now. But these are ‘lagging’ indicators; their movement ultimately depends on what is happening with business investment and, behind that, profitability.
And the latest figures on US corporate profits that came out last month for the first half of 2016 make dismal news. US corporate profits fell 4.9% in Q2 2016, compared to this time last year. And after tax was deducted, profits were down 6.3% compared to last year.
Corporate profits are the main driver of business. Where profits go, business investment is soon to follow, like the usual ‘night follows day’ proverb. And there is yet new evidence that this is right. Emre Ergungor is a senior economic advisor in the research department of the Federal Reserve Bank of Cleveland. He has been working on a model that can predict economic recessions.18 Most existing models try to predict recessions based on the movement of short-term and long-term interest rates, but they are not very good. Currently such models are reckoning the likelihood of a recession at no more than 20%.19
But Ergungor came across a startling fact: there is a very high correlation between the movement of business profits, investment and industrial production! He found:
A simple correlation analysis shows that the correlation between the change in corporate profits and the contemporaneous change in industrial production is 54%, but the correlation goes up to 66% if I use the one-quarter-ahead change in industrial production. Similarly, the correlation between the change in corporate profits and the contemporaneous change in gross domestic private investment is 57%, but the correlation goes up to 68% if I use the one-quarter-ahead change in investment. More formally, a Granger causality test indicates that the quarterly change in profits leads the quarterly change in production by one quarter, but the change in profits is independent of the change in production. A similar relationship applies to the quarterly change in profits and investment. Thus, firms seem to adjust their production and investment after seeing a drop in their profits.
This is very similar to the correlations and Granger causality tests that I and others have found.20 The time gap between profits and investment is about three quarters of a year. So Cleveland developed a new recession model to include corporate profits and found:
In early 2016, model 3 assigned an 81% probability to a recession in the next 12 months, and model 4 assigned a 73% probability to the same event. Thus, the consideration of the decline in corporate profits in this period worsened the recession probability by eight percentage points. As credit spreads declined later in the period, the recession probabilities from both models declined to around 30%.
Cleveland cautions that its model does not always predict a recession. But the model is way better than one based on interest rates only.
I have spelt all this out in detail because it adds yet more evidence to the Marxist economic case that it is profits that matter and investment that decides, not the price or quantity of money (monetarism) or consumption and employment (Keynesianism). So expect business investment to fall further over the next few quarters. If the Fed decides to hike interest rates in the middle of that, it could well trigger a new economic recession, should stock markets fall and the fictitious financial value of companies be exposed to the reality of their profits.
Michael Roberts blogs at https://thenextrecession.wordpress.com
Michael Roberts’ new book is now available: The long depression Haymarket Books, pp380, £14.99
1. See https://thenextrecession.wordpress.com/2015/08/31/getting-out-of-the-jackson-hole.
15. See http://delong.typepad.com/kalecki43.pdf.
16. See https://thenextrecession.files.wordpress.com/2016/08/fed-on-investment.pdf.