A recession, a crash? Wait a minute, not so sure…

The doomsayers are out with a vengeance. If you type recession in Google or YouTube, you’ll be told that the “recession is inevitable” or ‘that we’re already in a recession’.

Hang on, wait a minute, was there not a huge recession in 2020? How is it possible to come out of that huge trough with a recession less than a year into the recovery? Double-dips indeed happen, there is no question about that, it’s well documented. The issue is elsewhere: nothing fits with the narrative of a conventional recession.

1. The limitations of nominal GDP

The great contribution of Classical Economy to the field is the realisation that prices are actually an information system. They tell economic agents where the opportunities and challenges are so they can best adjust. Indeed, over the years, modern economies have developed highly sophisticated statistical apparatuses to monitor the economy. With wire transfers and credit cards, most monetary transactions are recorded, giving policy makers the impression that they actually know what is happening in the real economy. This is misguided. The nominal GDP is only one way to measure production. There are other ways. Simple ones, like counting the number of produced goods. By that measure, it makes no doubt that China is now the first economy in the world. Just count the number of cars, phones, TVs, washing machines…or even face masks, they produce, you’ll have to concede that its nominal GDP does not reflect the reality.

Not all economic activity results in the making of things, you might say. We all agree on that. Most of the economy is constituted by services we give one another. Often, these services are paid in cash, so they escape the scrutiny of states. This is why some of them push for the abolition of cash, a very bad idea indeed. And most services we give one another are not even compensated. The help we give family members, friends is often an exchange in kind.

2. Energy consumption = economic activity

So how can we measure economic activity if it evades monetary accounting? Well, there’s an easy answer to that: you need to consider that economic activity is more or less equivalent to energy. In the Roman Empire, you would have counted wheat quantities, today we count energy consumption. Which, for good or ill, is still mainly dependent on fossil fuels. Let’s look at oil, the most convenient and widespread of them all:

On the consumption side, the world went from consuming 98 millon barrels/day in February 2020 to consuming 82 million barrels/day in March 2020. This is a 16% drop month-over-month, an enormous recession! If we look year-over-year, then it went from 100 barrels/day on average in 2019 to 92 barrels/day on average in 2020, an 8% drop, aka recession! Still, on its home page, the same U.S. Energy Information Administration still claims there was only a 3.2% world recession in 2020… There might be a simple reason for the gap between the two indicators: governments count handouts as GDP, so if you were sitting at home for months, doing nothing with your life, your car rusting in the garage, as long as the government paid you for doing so, it was counted as GDP.

On the production side, we can see that it’s taking time for production to recover and it seems it will take even longer to accelerate. That’s normal: it takes a few hours to stop an oil rig, it takes months to identify where to drill, get the permit, and get the first barrels out. It’s an asymmetrical process. The same is true with the workforce, all managers know that: it takes seconds to fire someone, in particular if they’re at fault, it takes months, if not years, to recruit the right person for strategic positions.

3. In the US, people are still going back to work and there is still some slack in the economy

Many analysts were quick to notice that the US employment situation did not correspond to an economy about to fall into a recession. The June Employment report tells us that the US is only 524,000 workers away from its peak in February 2020. More importantly, if we look closely at some key sectors, we are told a very interesting story: the US is now back in the business of making goods, and producing commodities! Manufacturing employment is still growing at a solid pace, adding 30,000 in a month, and reaching its pre-pandemic level, which was already quite high by many standards. Mining, which includes oil and gas extraction, is also growing reasonably, although there is still some slack: mining employment is only 86,000 above its pandemic low.

4. Post-pandemic supply-side issue

Looking beyond aggregate figures, the story is simple. The world voluntarily decided to cut its production in order to fend off a potentially disastrous pandemic. Was it a good solution? We will long have this debate. But what matters is that we all knew from the start we could not cause major disruptions like this and restart the economic machine at the push of a button. Some tried to warn, but it was impossible to have this conversation and the advice was mostly disregarded. Not that it was difficult a guess for those, involved in production, whether they’re managers or entrepreneurs. Take the example of schools: they’re not only a teaching institution, they’re evidently a day care service. No modern economy can run without a robust schooling system. From an economic standpoint, closing them was simply suicidal. Like putting restrictions on so many aspects of our lives which are necessary for the economy to run properly: public services need to be open, transport needs to be cheap and easy, and foremost, economic agents need to be able to plan in advance, knowing that they will not be thwarted by some new Covid wave or worse, a war. Remember that trip you cancelled several times before abandoning the idea altogether? Remember that business idea which you put aside for two years?

5. Blaming inflation on interest rates, what a strange idea!

In this context, blaming inflation on the monetary policy of central banks seems rather weird. If you push heavy on the brakes, then your car stalls, you’re not going to blame it on the carburetor, are you?! This is exactly what is happening. The hawks are out. “We told you so” and “central bankers are irresponsible” is the chorus they like to sing, following Milton Friedman, “inflation is always and everywhere a monetary phenomenon”. Useless truism if there ever was one. Inflation is, in a monetary economy, indeed a monetary phenomenon. By definition. Does that tell us that only monetary policy can cause inflation? Well, that’s what Milton Frideman wanted us to believe, except that after the big Covid shutdown, we all experienced first-hand this is definitely not the case.

Firstly, there is not one inflation, there are always various inflations on various markets, the compound of which we call ‘inflation’, or more technically speaking Customer Price Index. This CPI has been widely debated for many years. It ages rapidly, and very often does not reflect the way people live at any one time. In the seventies, they certainly did not see it fit to include mobile phones and the mobile subscriptions in its calculation. So, it has to be modified at regular intervals, which threatens its relevance. A conundrum for statistical offices in most countries. Still, just as price is information, inflation figures in the form of CPIs is important information which should not be overlooked.

However, it has to be put into context. The oil market speaks for itself: to avoid operating at a loss, oil producers cut their output, and now it’s taking time to restart, thereby creating price spikes. This was further compounded by the war in Ukraine which, some would have us believe, could possibly lead to shortages. There is fundamentally no reason why the war in Ukraine should lead to oil shortages. Oil is highly fungible, easy to transport, easy to stock. If Western sanctions have any impact at all, it is a rearrangement of the oil market. Like in a game of musical chairs. By refusing to buy oil from Russia, Western countries are simply turning to other suppliers, whose place is in turn taken by Russia. It has nothing to do with interest rates and monetary policy. The latest quarterly GDP figures in China tell us just that: by locking down many major cities and regions, China could not help but slow its year-on-year growth to a paltry 0.4%. No economist could pretend, in their own mind, this outcome has anything to do with monetary policy. So why pretend it has when the economic machine is simply spurting out while in the process of restarting?

6. A lot of regional differences throughout the world

Let’s look closer at the situation in various regions of the world.

As mentioned above, China has stalled or is perhaps in a recession because of the restrictions it imposed on huge swathes of its territory in order to curtail a new wave of Covid-19. Nothing to do with monetary policy.

Europe is apparently falling into a recession because of the harm it is inflicting on itself due to the sanctions it aimed at Russia. Let’s remind ourselves that, contrary to other regions, Europe is far from self-sufficient on the energy front. For ideological reasons, it has decided not to exploit its own resources through fracking. So if it does not import oil and gas from Russia, it has to import oil and gas from other places, like the US (even though it originates from fracking). Europe was also an important supplier of Russia, in particular Germany. And when Germany catches a cold, the whole of Europe sneezes. Therefore, the odds are Europe will indeed undergo a small recession. Nothing to do with monetary policy.

Then there is the US, where the situation is completely different. Employment is back up, high energy costs will translate in added revenue for domestic producers, and it was never a big supplier of Russia. So there is a real possibility that the United States will skirt a recession.

Finally, there is also the rest of the world. Most emerging economies have been battered by the pandemic, all the more so as they did not have social security nets like in the West. Therefore, they have a long way to fully recover. A recovery that has been helped or hampered by the inflation on most commodities, depending on what each country exports and imports. For instance, Indonesia, Argentina, Saudi Arabia and many other countries are now growing at a 5 to 10% pace year-over-year.

All in all, the World Bank is forecasting a 2.9% growth in 2022 for the world. A far cry from a generalized recession.

7. Tensions on commodities markets are already easing out

If one looks at the various commodities, one sees each commodity is undergoing its own inflation cycle. Here are a few examples, with prices in USD:

Oil is coming under control, reaching its 2014 price (USD per barrel):

If we focus on the recent period, we can see that tensions on this already tight market were clearly exacerbated by the war in Ukraine, the large price swings, since the war in Ukraine started, showing the role played by speculators.

Oil since the war in Ukraine started (Brent sort, USD price per barrel):

Then, there is Gas. The price of which is now under control (USD price per MMBtu):

Steel went mad but came back to earh (USD price per tonne):

Copper has swiftly retreated in the past months, reaching its 2013 level (USD price per tonne):

Wheat has quickly dropped in the last weeks to its early 2014 level (USD price per bushel):

Corn literally plummeted in the last few days to settle well under its early 2014 price (USD price per bushel):

8. So what is this fuss about interest rates all about?

It’s very likely that all the information above is known to central bankers and the related indicators closely followed by them.

Nevertheless, the hawks will not have it and they’re spinning their own little narrative. That the inflation was created by exceptionally low interest rates and quantitative easing…that to stop inflation growing even further, it’s time to raise interest rates aggressively now, even if it means sending our economies into recession…

First, we should notice that historically-low interest rates, if raised by 50 basis points or even a full percentage point, will remain historically low… But more importantly, if inflation raged indeed at 8.6% (eurozone) and 9.1% (US) in June of this year, then borrowing at 2% is an amazing bargain because it means negative interest rates of 6.6% and 7.1% respectively. Far more interesting than borrowing at 1% when inflation is near zero. Economists, analysts alike seem to have forgotten that the inflation of the seventies was a boon to the boomers who therefore had their first home paid in part by inflation.

If interest rates rise moderately, while workers are able to wrench out their deserved pay rise, then not only can they recoup part of their lost income, but also can they purchase assets hereto inaccessible to them. To the detriment of those living off their assets.

9. The fact that monetary policy has become mostly irrelevant is attested by the numerous asset bubbles it created

The aim of any monetary policy should be to act on the real economy. One can but notice that this is increasingly not the case. After bursting the dot com bubble, the US economy created a housing bubble which led the world into the great financial crisis. Contrary to all moral standards and a shared realisation that those effectively running the economy were not on Wall Street but busy delivering us the essentials of life, Central Banks created new asset bubbles along the way: stock market, housing market, cryptocurrencies etc. The money went to investors, who put it into whatever asset class they thought could potentially turn them a profit, without any consideration for its relationship to the productive economy.

The case of cryptocurrencies is enlightening. Warren Buffet would argue, rightly I think, they’re not even an asset. The whole purpose of Bitcoin and the slew of tokens which followed suit is indeed to artificially create scarcity by limiting the creation of new tokens. In the romantic maelstrom of the crypto saga, there indeed coexist the best of engineering with the worst of economic thinking. It’s as if the creators of Bitcoin had dug out an old book from their own library, written at the time bankers were arguing about demonetizing silver in favor of gold only, a book therefore written slightly before 1873. Thus, the whole crypto ecosystem is bent on creating scarcity of something which can be indefinitely expanded, by nature, for the simple reason it is electronic…which is quite a paradox… No wonder cryptos attract speculators. It’s by design. No wonder a large chunk of the liquidities created by central banks since the start of the pandemic, ended up in cryptos, sending the Bitcoin to an all-time high of $60,000 (divided by 3 to $20,000 at the time of writing). But what do you need cryptos for? There are quite a few use-cases, that’s for sure, but they do not justify such hefty valuations. Let’s not forget transactions costs on Bitcoin and Ethereum are still so high they prevent their everyday use. The crypto bubble seems to have been solely the result of an abundance of liquidities fallen into the wrong hands.

10. Central Banks have become experts at creating liquidities, but they still cannot funnel the money where it is most needed

There is a structural problem here. Central Bank and the Finance Ministry are essentially two different agencies in charge of the same thing, aka the money supply. When the Finance Ministry creates a deficit, it means the public sector is creating money. When the Central Bank encourages the private sector to borrow, it also leads to the creation of money. By separating Central Bank and Finance Ministry, it becomes very difficult to coordinate the two. The Central Bank does not have a say on where the money created by the Ministry of Finance goes. It could go to the defense industries, it could pay for foreign imports of oil, it could also go to households in the form of exceptional Covid payments (up to $2,000 per adult in the US). Each measure having a very different economic impact. When the private sector is taking up the debt, the Central Bank has even less control, somehow influencing interest rates, maturities, and accessibility to loans. But a private market is in the hands of private agents who make individual decisions when they’re not simply displaying herd behaviour. Conscious of those limitations, in the aftermath of the 2008 financial crisis, Central Banks started to act directly on some of those ‘secondary’ markets, buying assets such as corporate bonds. By so doing, Central Banks are better able to influence market conditions for private companies. Even so, most of the money created by the private sector, and to a lesser extent, by the public sector, has inflated asset bubbles on the stock market, housing market and crypto market. So, while most people were struggling because of the pandemic, the upper-middle class saw the value of its assets rise, bringing some markets to dangerous levels.

11. So, Central Banks are reduced to monitoring, minimizing and deflating asset bubbles

You could argue that the US Federal Reserve and the European Central Bank know precisely what they are doing. Indeed, they are monitoring commodity prices very closely, so they must be aware that the inflation on some of these commodities is only temporary. They also know that raising interest rates by such a small margin is very unlikely ‘in and of itself’ to tame inflation. So why are they raising interest rates you might ask? The answer may have more to do with asset bubbles. They may be trying to deflate them before they burst. And, so far, it seems to have worked nicely.

All major stock market indices have now retreated to a level much closer to their long-term trend.

Standard & Poor:

Nasdaq:

Euro Stoxx 50:

Crypto markets have now dipped to a level which is going to force out all the speculators and ordinary joes who should not have been there in the first place, redirecting vital financial resources and attention to the productive economy.

Bitcoin in USD:

Ethereum in USD:

Finally, the housing market has been tamed. Preliminary data show it’s clearly not a crash, but inventories are rising to levels which are still below what they were at the onset of the pandemic. There is now a downward pressure onto prices which means buyers will have more bargaining power. And in some select markets (some US States, Canada, parts of the UK, parts of France), prices are coming down slowly. One can notice that with rents up almost everywhere, and negative real interest rates because of the high inflation, conditions are a far cry from those normally leading to a crash.

12. Central Banks now have to take into account the social media clamour

I recently heard an analyst from the Financial Research House GavKal make a very interesting point: “because of the rise of social media, whenever something bad happen, let’s say it’s Covid or Russia invades Ukraine, immediately there’s a clamour on social media, that something must be done”. Therefore, the small interest rates we’ve seen or we’re about to see may also be a way to deal with the social media clamour. The latest interest rate rises seem therefore to work several ways: it deflates asset bubbles, it calms inflation expectations, and it gives the social media crowd something to chew on.

We should also realise that most of this chatter, this clamour is aimed at the Modern Monetary Theory crowd who, for years, have been advocating more spending, larger deficits to bring developed economies to real full employment, something we haven’t seen for decades. In August 2019, one of its proponents, Stephanie Kelton, was lamenting that “MMT may be Democrats’ economic cure but only Trump got the memo.” Since Biden took office, we cannot help but notice that the new democratic administration is relying heavily on the same recipe initiated by the previous US administration. For all the differences in style, there is indeed great continuity between the economic policies of Trump and Biden, the former having initiated a period where budget deficits are typically between 3 and 5%, a period the latter is dutifully extending.

Conclusion:

Although for the monetary hawks and some uninformed analysts, the current inflation is mostly the result of reckless monetary policies, a careful analysis of regional differences and the latest developments on some commodity markets show most of it can be traced back to supply-side issues following the restarting of the global economy in the wake of the Covid pandemic. The Ukraine war exacerbated those tensions because, on the one hand, it required the global supply chain of oil and gas to be reorganized and, on the other hand, it attracted speculators. The recent and forthcoming interest hikes will likely dampen the appetite of speculators on the various asset classes, while not slowing growth too much. This reduced growth will translate into even lower commodity prices, helping tame inflation further. This positive feed-back loop will then help growth reaccelerate. This positive scenario can unfold if two conditions are met: no more major disruptions to the economy caused by Covid, a de-escalation process from NATO and Russia in Ukraine, whether it’s a peace agreement, a victory from Russia, or the installation of a low intensity conflict for several years. Provided governments keep substantial budget deficits, interest rate hikes will not have much of an impact but will serve to deflate commodity and asset bubbles. Simultaneously, salary negotiations which are bound to happen all over the world should not be rushed, to allow the first signs of decelerating inflation manifest themselves. More importantly, they should be taken as an opportunity to rebalance the income structure of modern economies in favour of the very same workers this bout of inflation has proven to be absolutely essential to production.