Putting the Hayekian horse back before the Keynesian cart, part III

Attempting an Austrian-based macro-economic approach to the business cycle

To return to our main theme, the next problem we face is that though they may provide a superior measure to GDP, the I-O numbers are only compiled with a lag of around eighteen months, a delay which condemns them to fall far short of having anything other than academic significance. Fortunately, the means do exist for us to reduce the waiting time on this greatly, as long as we are prepared to work with less comprehensive numbers.

If we regard this as a reasonable trade off — and we shall see that the results turn out to justify this assumption tolerably well — we can avail ourselves of the more timely data relating to corporate expenditures, and so cut the gap to a more reasonable four months. Indeed, using both the BEA report on corporate profits and the Federal Reserve’s Flow-of-Funds version — deriving an estimate of gross inventory spending from a combination of the former’s net flow data and the latter’s valuation-adjustment and balance sheet stock data — we can construct a Corporate Spending Index, or CSI, an estimate whose year-to-year nominal changes enjoy an impressive r-squared of 0.94 with our overall aggregate we have previously distilled from the GDO numbers.

Taking this a further step, we can attempt to construct a third series, based on monthly statistics, again by accepting a little more noise in exchange for punctuality and, in this way, we can try to reduce the knowledge gap to around six weeks. To do this, we notice that, according to our manipulation of the corporate data, for every $100 spent on factors of production over the past decade (rather than on taxes or as a return on capital), $62.50 dollars are typically paid out to the labour force; $14 takes the form of fixed investment spending (split 70:30 between equipment & software and structures); around 70¢ represents net inventory changes; and the balance can be ascribed to the replacement of existing stock.

Of the accessible monthly series which related to these, three of those published by the Census Bureau fit the bill: namely, that for total manufacturing shipments (less those of consumer goods) — which provides a fair approximation to corporate plant and equipment investment; the private non-residential construction spending figure which mirrors the structures investment component; and the sum of inventories reported at each of the manufacturing, wholesale, and retail levels which provides a close match for overall net inventory changes.

Adding to this the monthly figure for wages and salaries earned at private businesses from the BEA — then weighting the collection by the percentages laid out above — and we now have our own Business Spending Index, or BSI (which we can also deflate to make some allowance, however imperfect, for changes emanating from the money side using, e.g., the Cleveland Fed’s Median CPI number).

At length, what we are left with - over what is admittedly a much shorter sample which starts only in 1992 — we find we are left with a still useful r-squared of 0.88 with our quarterly CSI measure, as well as with a pleasingly respectable r-squared of 0.68 with our original annual GDO series.

As a final crosscheck — one which suggests a further avenue for research, since we only have recent, partial figures currently at our disposal — we can loosely compare the magnitude of changes with those reported by the financial newswires for revenues of the S&P500 population, in toto. Though not shown here, changes recorded over the past few years have indeed been roughly consonant with one another

As the accompanying graphs show, the undeniable facts are that, having last summer attained a level only bested by that of the 2000 peak, business spending has slowed appreciably since that time — though not yet to levels which have typified recessions — and, moreover, there have been tentative signs in the latest readings that the drop may have begun to stabilize last month, before the present turmoil erupted.

One final observation of relevance is that, in general terms, each of these indices shows a good deal of co-movement with commodity prices — as measured, for example, by the continuous CRB index — though, equally, the fact that such prices are not wholly determined by factors at play in the US also shows up in the divergence evident during the period of the Asian Contagion when the prostration of the Tiger economies more than overpowered what was only a mild deceleration Stateside.

Reading the runes

But if all of this tells us better where we are, we still need to think about what may drive our indicator further ahead, or potentially divert it from its present course. Though there is an element of chicken and egg in trying to analyse a dynamic system by means of static, aggregate measurements, we can say that if sales seem to be holding up — especially where a good portion of these are being generated by meeting customers’ investment needs (since these are not then subtracted as a current cost from their earnings totals) — overall profits have a chance of doing likewise. Similarly, if strong profits are being generated in relation to the incurrence of associated labour costs, employment levels will probably be maintained or expanded.

In each case the latest quarterly data were still supportive, even though the housing slump showed up clearly, too. In fact, last year, the rolling 4-quarter increase in gross fixed capital expenditures at non-financial corporates was 14.6%, its fastest nominal pace since 1998, while the gain in the net figure (with and without adjustments for price changes) was the best since the mid-80s. Moreover, a comparison of the renormalized trajectory from the trough of the real, net outlay with that of the previous two long-lasting US expansions of the mid-60s and the 1990s shows a distinct resemblance in all three cases.

As for job prospects, the money disbursed by non-financial corporates to its workers as a percentage of net value-added, while having ticked up in QIV, was still at levels only matched once before in the past three-and-a-half decades.

Thus far, the story has been supportive of the tale of sectoral rebalancing which we have propounded this past year. Add to this a 10% price rebound from the lows, coupled with indications of strengthened demand, for what we have elsewhere described as today’s main Keynesian injection mechanism — namely, energy* — and we could have been looking ahead with some confidence to a renewal of the upward trend in both industrial activity and commodity prices sometime later this year.

It is clear however, that just as the real world cannot fail to have an impact — however peripheral it may sometimes appear to be — on the financial world, so there are profound linkages running the other way, as is inherent in the whole Austrian conception of the business cycle as a manifestation of the credit cycle.

Thus, we cannot fail to be aware that the same monetary accelerant whose application and subsequent cessation has had such disastrous consequences for the US housing market is more than likely to have infected a whole range of entrepreneurial decision making outside that narrow sphere. Thus, if falling asset prices and the growing losses being booked by lenders provoke a more widespread tightening of credit and/or a reduction in its availability, past malinvestments will be uncovered in hitherto unsuspected areas and the rot may well spread sufficiently to cause the whole superstructure to crumble.

In this context, we are so far comforted by evidence that our sweep-adjusted Austrian Money Supply measure (based loosely on Charles Hatch’s insights) has turned up smartly from its September lows; that the traditional US monetary aggregates have been accelerating in recent weeks (both M2 and our regression-extrapolated M3 aggregate); that, within this, specifically commercial and industrial loan growth has picked up after an autumn lull; that the latest monthly NFIB survey of small business was sanguine as to credit conditions; and that the increase to date in the quality spreads, as well as those seen in both real and nominal yields, of BAA industrial bonds have been fairly well contained, keeping them each below their average values of recent years.

The question we ultimately have to face then is this: if the real world may be faring better than it appears — once we examine it from its proper perspective — does the converse apply to the financial system? If the answer to that is, “yes”, then we have to be prepared to accept that in a world which disports such an over-developed, over-leveraged financial system as ours, the monetary tail can not only sometimes wag the dog, but that if it begins to whip around too violently, it may occasionally happen that it snaps the poor beast’s spine completely in two.

Cave canem, indeed!

*The idea here, in short, is that with 90% of oil reserves under state control and with most major oil exporters either having currencies pegged to the US dollar, or utilizing ‘stabilization’ funds with which to absorb receipts, dollars borrowed to pay for oil are rapidly recycled via a Rueffian ‘childish game of marbles’.

Sean Corrigan

Sean Corrigan is Chief Investment Strategist at Diapason Commodities Management (Lausanne and London)

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