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Wednesday, 6 November 2019

Breaking the economic cycle of every 10 year a new US recession (2)

The most fundamental item in economics is scarcity (eg, raw materials, goods, drinking water, money). Scarcity defines market prices because demand will exceed (scarce) supply. In the absence of scarcity, prices tend to be (very) low. Hence, low interest levels are also the result of abundant supply of money and limited demand for it.

In most business cases, interest levels are hardly relevant as expected profitability of new products or services is usually far higher than (tax deductible) interest charges. Moreover, a discounted cash flow calculation is hardly relevant when the payback period of an investment is 2 to 4 years. Interest only becomes relevant in long payback periods.

The abundant money supply (eg, quantitative easing) by Central Banks is rooted in the idea that cheaper interest rates will boost the economy. In case of interest charges above 10%, this notion is probably valid. However, when interest rates are close to zero, this notion no longer applies as has been clarified above.

The fiercest criticism on low interest levels comes from pension funds facing exploding future commitments, following the mandatory use of lower interest levels in their discounted cash flow calculations. Hence, the need for pension discounts is a hot topic. Also see my 2019 (Dutch language) blog on pensions and discount rate.

Several articles are warning that the Central Bank policies of low interest rates and abundant money supply, may cause decades of low economic growth (eg, BloombergFT, my recent blog). Today, this phenomenon is called Japanification. Previously, secular (long-term) stagnation was used, a term coined by Alvin Hansen in 1938, and later popularized by Lawrence "Larry" Summers.

Any abundance in supply will cause misallocations in markets, following these low market prices. Government involvement in demand and/or supply usually has a similar impact. The Central Bank policies of low interest levels are mainly causing asset price inflation (eg, real estate) rather than consumer price inflation (CPI). Also see my 2019 blog: The inflation conundrum.

Breaking economic cycles has an upside and a downside. The upside is that we seem to be able to avert - but probably just postpone - the cycle of every 10 year a new US recession. The downside is Japanification or secular (long-term) stagnation.

In a June 2019 FD interview, Austrian economist Gabriel Felbermayr compared the economy to a living organism: "the ECB stuffs it with pain killers, we feel nothing anymore" (my Dutch blog). Any sickness then becomes very serious. Hence, my fear for The Great Rebalancing.

Once in a lifetime (1981) by Talking Heads

Note: all markings (bolditalicunderlining) by LO unless stated otherwise

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