Understanding the Current Economic Cycle

Summary

The speaker discusses the uniqueness of the current economic cycle compared to past experiences, emphasizing the importance of understanding income-driven expansions and their impact on monetary policy and asset prices. They highlight the confusion caused by the absence of traditional credit creation and the shift from credit or money-driven to income-driven economic cycles. The speaker suggests that the main factor leading to a recession would be a rise in long-term interest rates, which would affect asset prices, spending, and ultimately employment and wages, creating a sustainable slowdown in demand.

Takeaways

• 🔄 The current economic cycle is distinct from previous ones, requiring a deeper understanding of its dynamics rather than just the unusual nature of its drivers.
• 💼 The speaker emphasizes the importance of recognizing second and third order consequences of income-driven expansions on monetary policy, asset prices, unemployment, and inflation.
• 🤔 There's a noted confusion among investors and policymakers, as the current cycle doesn't fit the traditional credit or fiscal-driven expansion models, which can be resolved by reframing thinking to an income-driven expansion.
• 🏦 The speaker points out that unlike previous cycles, there is minimal credit creation occurring among households or businesses, yet the economy continues to expand.
• 💡 The traditional income-driven expansion is highlighted as the oldest type of economic financing, where spending leads to income, which in turn leads to more spending in a sustainable cycle.
• 📉 The speaker suggests that asset prices falling, likely due to rising bond yields, could be the catalyst for a shift in consumer behavior from spending to saving, potentially leading to a recession.
• 📈 Despite the absence of significant credit or money creation, asset prices are rising, and the economy is growing, indicating a different type of economic driver at play.
• 💬 The Federal Reserve's confusion is mentioned, with an example of an essay by Neil Kashkari that questions the effectiveness of monetary policy in the current cycle.
• 🌐 The script discusses how business cycles and expansions have commonalities across countries and time, suggesting that the current cycle is not as unusual as it may seem.
• 🏁 The speaker anticipates no recession in the near future, as the conditions that typically lead to one (credit growth slowing down, money growth slowing down) are not present.
• 🛑 The path to a recession, if it occurs, is likely to start with long-term interest rates rising, which would affect asset prices, spending, earnings, incomes, employment, and wages, eventually leading to a slowdown in demand.

Q & A

What is the core idea discussed in the transcript about the current economic cycle?

The core idea is that the current economic cycle is different from past cycles, requiring a deeper understanding of the dynamics driving it, which are unusual to us but common in the context of historical business cycles and expansions across countries and time.

What does the speaker suggest about the nature of income-driven expansions and their consequences?

The speaker suggests that income-driven expansions have second and third order consequences for monetary policy, asset prices, unemployment, and inflation, and understanding these can help in framing and comprehending current economic conditions.

Why might the current economic cycle be confusing to some?

The cycle is confusing because it differs from credit or fiscal-driven expansions. It lacks the usual credit creation among households or businesses, yet the economy continues to expand, which contradicts the traditional economic models.

What does the speaker mean by 'reinforcing mechanism' in the context of economic cycles?

A 'reinforcing mechanism' refers to a self-sustaining process where one economic activity leads to another in a positive feedback loop, such as increased spending leading to income, which in turn leads to more spending.

How does the speaker describe the relationship between asset prices and consumer spending?

The speaker describes a scenario where rising asset prices and good wage growth encourage consumers to continue spending, as they feel wealthier and have less incentive to save.

What is the speaker's view on the role of monetary policy in the current economic cycle?

The speaker believes that monetary policy has been less effective in the current cycle due to the absence of credit creation and suggests that the focus should be on income-driven dynamics.

What does the speaker suggest as the primary factor that could lead to a recession?

The speaker suggests that a recession could be triggered by a rise in long-term interest rates, which would hurt asset prices, reduce consumer spending, and eventually affect earnings, incomes, and employment.

How does the speaker explain the difference between a 'spiral' and a 'reinforcing mechanism' in economic terms?

A 'spiral' implies an uncontrolled, escalating cycle, either upwards or downwards, whereas a 'reinforcing mechanism' is a more stable, sustainable process that can continue for an extended period without leading to extremes.

What is the speaker's perspective on the current state of credit creation?

The speaker notes that there is essentially no credit creation occurring among households or businesses, which is at recession-like levels, yet the economy continues to expand.

What does the speaker imply about the role of fiscal policy in recent years?

The speaker implies that despite a fiscal contraction over the last three years, the economy has continued to grow, and asset prices have risen, suggesting that the current expansion is not fiscally driven.

What is the speaker's view on the necessity of bond yields rising to create a recession?

The speaker believes that rising bond yields are a prerequisite for a recession, as they would lead to falling asset prices, reduced consumer spending, and a subsequent slowdown in economic activity.

Outlines

00:00

🔍 Understanding Unusual Business Cycles

The speaker emphasizes that the current economic cycle differs from past experiences, requiring a deeper understanding of its driving dynamics. They highlight that income-led expansions have significant second and third-order effects on monetary policy and asset prices. The confusion stems from the unusual nature of the cycle, which contrasts with credit or fiscal-driven expansions. The speaker suggests that reframing the perspective to an income-driven expansion can provide clarity. They also mention the Federal Reserve's (FED) stance and the public's confusion about the current economic situation, suggesting that the cycle's unusual nature is the root of the misunderstanding.

05:00

📉 The Role of Asset Prices and Income in Economic Cycles

This paragraph delves into the factors that could lead to a recession, focusing on the importance of asset prices and income growth. The speaker argues that a recession is unlikely unless there is a significant change in consumer behavior, such as increased saving due to fear or falling asset prices. They explain that rising bond yields could be the catalyst for falling asset prices, which in turn would affect spending, earnings, incomes, employment, and wages, eventually leading to a slowdown in demand. The speaker also discusses the sequence of events that could lead to a recession, emphasizing the importance of long-term interest rates and the potential for an exogenous shock to disrupt the economy.

Keywords

💡Business Cycles

Business cycles refer to the fluctuations in economic activity over time, characterized by periods of growth and contraction. In the video's context, the speaker highlights that the current cycle is different from past experiences, requiring a deeper understanding of its dynamics. The script mentions how business cycles and expansions have occurred across countries and time, indicating a historical pattern that is being revisited.

💡Income-Driven Expansion

An income-driven expansion is an economic growth phase primarily fueled by increases in income rather than credit or fiscal measures. The speaker in the video emphasizes the importance of recognizing this type of expansion, as it leads to different outcomes in terms of monetary policy and asset prices. The script discusses how this traditional form of expansion has second and third-order consequences, affecting unemployment and inflation.

💡Monetary Policy

Monetary policy refers to the actions of a central bank, such as the Federal Reserve, to control the supply of money and interest rates to influence economic activity. The video script points out that the dynamics of the current economic cycle may confuse traditional monetary policy approaches, as growth does not seem to be slowing down despite tight monetary conditions.

💡Asset Prices

Asset prices represent the market value of financial or physical assets. The script discusses how asset prices are likely to be affected by the type of economic expansion, with the current income-driven expansion leading to an increase in asset prices, contrary to what might be expected during a credit-driven cycle.

💡Unsustainable Debt Creation

Unsustainable debt creation occurs when the amount of debt being taken on by individuals or institutions exceeds what can be repaid without causing economic harm. The video script uses the example of the 2006-2008 housing bubble, where excessive credit growth led to an unsustainable situation, eventually requiring monetary policy intervention to slow the cycle.

💡Credit Creation

Credit creation is the process by which banks and other financial institutions lend money, thereby increasing the supply of money in the economy. The speaker notes that in the current economic environment, credit creation is at recession-like levels, yet the economy continues to expand, indicating a shift from traditional credit-driven growth models.

💡Fiscal Policy

Fiscal policy involves government spending and taxation to influence economic activity. The script mentions that after the COVID-19 pandemic, there has been a fiscal contraction, yet economic growth persists, suggesting that the traditional relationship between fiscal policy and economic growth may be less relevant in the current context.

💡Income Growth

Income growth refers to the increase in the earnings of individuals or households over time. The video emphasizes that income growth is a key driver of the current economic expansion, as it directly affects consumption patterns and, consequently, economic demand.

💡Asset Price Volatility

Asset price volatility is the variability in the market value of assets over time. The script suggests that falling asset prices could create an incentive for individuals to save rather than spend, which could lead to a slowdown in economic activity. This is a critical factor in the potential onset of a recession.

💡Bond Yields

Bond yields are the returns earned on bonds, which are influenced by interest rates and market demand. The video script indicates that rising bond yields could be a precursor to a recession, as they may lead to falling asset prices and reduced consumer spending.

💡Recession

A recession is a period of negative economic growth that lasts for at least two consecutive quarters. The script discusses the conditions that could lead to a recession, such as a rise in bond yields and a subsequent decline in asset prices, spending, and income, ultimately affecting employment and wage growth.

Highlights

The current economic cycle is distinct from past experiences, requiring a deeper understanding of its dynamics.

Income-led expansions have second and third order consequences for monetary policy and asset prices.

The gap in understanding stems from a failure to recognize traditional income-driven expansion patterns.

Monetary policy confusion is evident in recent Federal Reserve communications.

Re-framing thinking from credit or fiscal expansions to income-driven can provide clarity.

Current economic expansion lacks the typical credit creation seen in previous cycles.

Economic growth persists despite minimal credit creation, challenging traditional economic models.

The role of money creation in driving asset prices and the macroeconomy has diminished.

The economy is experiencing a type of expansion financing not driven by credit or money creation.

Historical periods of stable money supply saw business cycles driven by income and spending.

The self-reinforcing income-driven mechanism is sustainable and not inherently a spiral.

Fiscal policy has contracted in recent years, yet economic growth and asset prices continue to rise.

The focus should be on income, rather than credit or money, as the primary driver of economic activity.

A recession is not imminent, as the conditions for one are not present in the current income-driven scenario.

For a recession to occur, there must be a decline in income growth and increased fear leading to reduced spending.

Asset price falls, driven by rising bond yields, are the likely catalysts for a shift towards a recession.

The sequence of events leading to a recession begins with long-term interest rate increases.

Last fall's taste of rising bond yields and subsequent easing illustrates the potential triggers for economic slowdown.

Transcripts

with the core idea that um the the cycle

that we're seeing today is very

different than the cycle than that we've

experienced the cyles we've experienced

over the course of our professional

careers and so they require uh the

ability to sort of step back and really

deeply understand um not the the fact

that the Dynamics that are driving them

are unusual to us but actually quite

usual quite common when you think about

how uh business Cycles have and

expansions have occurred you know across

countries across time which is that core

idea of an income Le expansion has a lot

of second and third order consequences

when it comes to monetary policy asset

prices um what's likely to transpire

with uh with you know unemployment

inflation Etc and so I think that's the

main Gap and and and I see it all the

time I see it for instance if you read

you know what the FED writes uh Neil

Kari came out with a with an essay that

basically is like I think monetary

policy is tight but growth doesn't seem

to be slowing down um you know somewhat

confused I think by the cycle that we're

seeing and I think a lot of investors

are confused by it but if you if you

reframe your thinking from credit driven

expansions or a fiscal driven expansion

to instead one that's a traditional

income driven expansion it's going to be

very very helpful in Framing and

understanding what matters and what

doesn't okay let me ask you one thing

before you go because that that I'm it

see it confuses me too and I imagine it

confuses a lot of folks as you point out

so why do you think it is confusing like

where do you think if you had to kind of

pinpoint where that comes from or what

that is what do you think it is well I

think the main thing that's confusing is

um we've had Cycles where inevitably

excesses emerge and where monetary

policy is effective at in excesses so if

you think about like the 06 to 08 you

know housing cycle housing bubble driven

cycle right we had huge credit growth

which got to a point where um where it

was totally unsustainable you know like

people were taking out greater than 100%

LTV loans with no doc financing you know

that didn't have jobs like that's the

sort of thing it you got to a point

where there's so much debt creation that

it was unsustainable that was going to

continue and you had a circumstance

where the fed's tightening

the raising of interest rates at that

time had was relatively effective in

slowing that cycle because 50% of the

loans were uh were uh financed on the

short end or were floating rate loans in

one form or another and so that's kind

of our our our framework that's the way

of our of our thinking but what's

happening today is that there is

essentially no credit creation occurring

uh among households or businesses it's I

mean there's not literally zero but

we're basically at recession like levels

of credit creation already and yet the

economy

expands and and so that's that's the

thing that's confusing is that if you

think about the economy through the lens

of credit being the driver and you think

about the economy uh through the lens of

money being the driver right because in

the post GFC period you know money

creation went up and down and up and

down and that drove waves uh in in the

in asset prices in the macro economy but

again what's happened in the postco

period is uh in the last couple of years

is that uh asset prices are going up the

economy is strong and money creation is

negative right and so what that

highlights is it's not money creation

it's not credit creation it's something

different it's a different type of

financing of an economic expansion and

it's a is it is in many ways the oldest

type uh of financing of an economic

expansion if you just go back to periods

where money supply was constant and

where there weren't well-developed Banks

how did to get business Cycles well

someone started spending and they handed

it to somebody and was somebody's income

and that person started spending and

they handed to somebody somebody's

income and that's a natural that's not a

spiral I think too often people go Oh

you mean there's a spiral it's not a

spiral it's just a rein a

self-reinforcing mechanism it's not a

spiral upwards or downwards it's a it's

a reinforcing mechanism a sustainable

reinforcing mechanism that can continue

for an extended period of time and

that's exactly what we're seeing is not

credit not money money um even the

fiscal story which really mattered right

after covid you know we've had actually

a fiscal contraction over the last three

years and nonetheless we continue to see

growth continue to plug along pretty

well and we continue to see asset prices

rise and it's all around that income

point so I also take it no recession

ahead or at least not anytime soon well

I think the main thing on the on on that

idea is um in order to get you have to

ask yourself what do you have to get in

order to get a recession uh and if it's

not credit growth slowing down and if

it's not money growth slowing down then

what you have to do is you have to you

have to get that income growth that's

happening you have to get people to

spend less of that income and how does

that work well the way that they spend

less of that income is they get scared

they you get scared that you have to

save more and spend less and so how does

that happen well the key way that that

happens uh is through asset prices fall

and so how are so because you know as

long as asset prices are going up and

you're earning a good wage like you keep

spending you know it's very natural that

people just keep spending as long you

know if you're again if you're a middle

class household like your house has gone

up 100% in value in the last you know

five years your 41k is up you know 50 to

100% in value in the last five years

like there's no reason to save right so

the question is what creates the

incentive to save and what creates the

incentive to save is falling asset

prices and what creates falling asset

prices in this environment is rising

bond yields and so that's when you talk

about when are we going to have a

recession we probably will have a

recession it'll happen at some point the

question is really the ordering which is

you start with uh long-term interest

rates have to rise and then that'll hurt

asset prices and then that'll hurt

spending and then that'll hurt earnings

and incomes and then that'll hurt

employment and then that'll start to

slow wages and then that will create

slowing uh a sustainable slowing of

demand but the path is that is in that

direction right so one has to the

ordering matters first Bonos have to

rise or I mean maybe there'll be an

exogenous shock but really first Bonos

have to rise that's the most you know

that's the the most likely way in which

this overall Dynamic starts to slow and

we saw a taste of that last fall but you

know Bon yels touched five and then they

went down and there was a big easing

that happened in response and so we did

really get that Dynamic to play out long

enough or high enough or painful enough

to start to really shift what's going on

with economic conditions and so the

question is not really when will uh when

will the recession come the question is

much more what has to happen to get to

the point of recession and the first

step of that is Bon's after r