Odd Lots - How Private Sector Balance Sheets Changed Recessions

Episode Date: October 21, 2019

Can the U.S. economy have a recession without it turning into a crisis? In the old days, such garden-variety recessions were fairly common. These days, less so. But why is this? And can we go back to the old-style soft recessions? The issue, arguably, is that private sector balance sheets (both debts and assets) have grown so large relative to incomes, that the value of financial assets swamp effects from changing incomes.On this week's Odd Lots, we speak with David Levy of the Jerome Levy Forecasting Center about his new report called Bubble Or Nothing about how the economy works in a world of gigantic balance sheets and extreme risk taking.See omnystudio.com/listener for privacy information.

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Visit the Collegeslacetre.com.ca. An initiative of the Consortium National of Formation in Health, supported by Santee Canada. Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthal. And I'm Tracy Allaway.

Tracy, obviously, we're in a moment in which there's a lot of debate about whether we're headed for an imminent recession, maybe in the next few months or maybe in the next year. Right. I think we're recording in the week that Jamie Diamond was talking about how we're definitely heading for a recession. The only question is timing, which is kind of always true, I guess. But it definitely feels like the chorus of people talking about a potential recession is getting louder. Yeah, between the trade war, the curve inversion, which as of right now is actually uninverted, some weak data in the U.S.

there's clearly, we're back on recession watch. There's no real doubt about that. But as you point out, we're always heading for recession and Jamie Diamond point out it's only a matter of time. At some point, we'll have another one. So to say we're headed for one, but we don't know why it's kind of obvious. Right. And I think we're still in the longest economic recovery on record now, right? So we're kind of due for something to happen. But I think there's a more. more perhaps interesting and consequential question for investors in the economy than merely when will the recession happen? What's that? Well, I think the bigger question is when the recession hits, what's it going to look like? Because we've been scarred recently or recent recessions

have all been pretty brutal in some sense. So if you think about the recession that started in 2007, the financial crisis that was horrible. The recession that came after the dot-com boom, it wasn't really devastating overall. And it was kind of quick, but, you know, it was a tremendous loss of wealth due to the crash in the stock market. And prior to that, we had a recession following the savings and loan crisis. So we don't have, we don't seem to have these sort of old-style recessions anymore. They always seem to be. accompanied by something big and systemic. Well, people who talk about recession now do seem sort of oddly hopeful that the next one is going

to be what they call a shallow recession, right? You hear people who talk about it every once and while and say, just because it's a recession, that doesn't mean it's going to be like 2008 all over again. We can have a contraction in economic growth without a huge crisis in the financial sector, but I think what you're getting at is whether or not that's true and whether the examples of recession slash financial crises that we've seen over the nearest past decades suggests that maybe that can't happen anymore. Yeah, this really is the big question. Like, we don't want to be too, I guess, scarred by recent events to say, oh, every recession now is going to be a crisis. But on the other hand, we don't want to dismiss the fact that

the sort of old business cycles as we know them have given way to financial market cycles. And that sort of is seeming to be the main driver. And in fact, you know, there's not a novel concept. Jerome Powell at Jackson Hall two summers ago kind of said the same thing that whereas the Fed and our traditional models think about tradeoffs of inflation and jobs and the sort of very sort of standard view of the economy overheating and then slowing down, the real game in town is what happens with asset prices and how it decline in asset prices spills over into real economic activity. Right. So if you think that the economy has become financialized, which a lot of people do seem to think nowadays, then it would stand to reason that when we get recessions, they're going to be financialized as well. I like

this topic, Joe. I like this topic, too. And we have the perfect guest for it. And we have the perfect guest for it today. Today we are going to be speaking with David Levy. He is the chairman of the Jerome Levy Forecasting Center. And he recently came out with a very interesting report called Bubble or Nothing. And it talks about how the private sector swelling balance sheets compel increasingly risky financial behavior. And it really addresses the role, the growing role that financial assets themselves play in the economy and in economic cycle. And so maybe in this conversation, we'll get an answer to, can we have old-fashioned recessions or are we doomed to have big crises or mini-crisis

that are resulting swings and prices? So without further ado, I want to bring in David Levy. Thank you, Joe. And hi, thanks for both you for having me here. These podcasts are just such a refreshing change from the Soundbite world. We don't spend too much time in, and I'm really excited to talk about it. And this is a great topic. We had you on TV a couple of weeks ago, and we talked for like six minutes, but it's so deep. I was like, we got to have them back and actually do something

really deep because it's such an important topic. But just to start off, would you say that our sort of characterization of the evolving nature of recessions is correct? Whereas in the old days, you think about the economy overheating, maybe factories, built too many widgets. There wasn't demand for widgets, the factories had to lay off some workers for a few quarters, they draw down the inventory of widgets, then they build them up and everything's back again. That just doesn't seem to be the way cycles work. I agree very much with the thrust, what you're saying. I'm going to try to paraphrase a little bit by saying what has changed is that as private sector balance sheets have become larger and larger relative to GDP, relative to personal income,

depending on which sector we're looking at, they have increasingly, dominated the cycle. So things like balance sheet effects, such as wealth effects, when the stock market goes up or down a lot, major refinancing effects, when there's vast amounts of debt, they get refinanced at lower rates and people pull cash up. These things have started to play a much bigger role. But also, you know, it's important to realize balance sheets have been involved in the economy. Their expansion is an essential part of how economies work. Sure. Economy cannot generate profits without balance sheets expanding. This gets into the flows of funds that give us profits, what we call the sources of profits, and it's a process

that is perfectly natural and normal. The problem is balance sheets having grown faster than income really since the end of World War II, a little bit on and off, but pretty much most of the time, we've got to the point eventually by the 80s where these balance sheet effects were starting to be distorting. And that has become more and more extreme. And that is why we see a lot of the distortion. It's why interest rates were forced down. It's by supporting these top-heavy, financially top-heavy economies. It's why rates of return were forced down. It's why there's a massive, a massive wealth that swings of which have huge influence on people's behavior. And that's really the new world we're in. It's not when we're going to be in

forever, but that is the one we're in now. So, David, you're saying that these big balance sheets basically mean that wealth has become more important and sort of bigger relative to income. And that means that wealth slash balance sheets have an outsized effect on the economy. But how did we actually get to that place? Why in the 1980s did balance sheets start growing in this way? If we go back to the end of World War II, we'd just been through 15 years of depression in war and balance sheets were extremely low.

No one had done much investing. They hadn't really been, they hadn't wanted to in the Depression. They hadn't been allowed to during the war. There was a huge pent-up cash. All the debt had been pretty much paid off or going bad by then. And at the end of the war, we had this tremendous boom rebuilding. And this meant expanding balance sheets. We had acid prices that were depressed by all the fears brought about by depression and then war.

And gradually people became more comfortable. So we had a normalization that went on maybe for up, let's say, into the 70s somewhere. There's no way to draw a precise line. But the problem is there's a certain inertia there and this this kept going. I don't have you know we don't try to explain exactly why it had to go We could have a long discussion about that and there are a lot of reasons to believe that there Were some forces behind it, but the important thing is we know what did happen and once you get to the point where you start to Balance issues are so big that to support them the Fed is forced to lower interest rates that it's not You know housing just weakening or or or car or

going down, but it's actually you have an asset market that's having a negative wealth effect or there are debt problems, a financial crisis that comes when interest rates go too high. Those are the balance sheets now start to take over interest rates. I want to talk a little bit about the sort of necessary Fed response when asset prices go down. But before we do, I just want to back up the Jerome Levy Forecasting Center. You talked about how you use a sort of sources of profits, sectoral balances, or balance sheet approach to understanding the economy. Can you just sort of talk a little bit more about what makes your approach to analyzing the economy distinct? Because when I read a lot of like sell-side research, I typically don't see a lot about sources of

profits analysis. No, no. This is, there are more people starting to pay attention to this. In fact, a piece which we give out complimentary, I don't know if I mentioned, where profits come from. It's just an educational tool. I know is used by a number of big investment houses. They started to get interested in it. It was introduced to the discipline in the 1930s by, to most people, an obscure Polish economist who was a contemporary of Keynes at Cambridge.

But it was, that was Michael Kuletsky. But he had a very left-wing view of about a lot of things. There's nothing left-wing about the profits. identity. Profits identity or profits equation is just a cousin of the very well-known saving investment identity. You just rearrange the terms because business saving is profits after taxes and dividends. So you can turn it into a profits equation and that is a much better causal way to understand what happens in the economy. When investment takes place and people decide not to save too much, a lot of that, the wealth created investment that isn't saved,

by households or governments ends up necessarily flowing to business and it becomes profits. So this way of thinking naturally ties into finance, you don't look at real concept, you're looking at financial flows because of the importance of investment when saving flows, it ties into balance sheet changes in a very direct way. Just to say, how does this different? There are people who are taught, you mentioned sectoral analysis where people, there's a strong tendency among a lot of people today to look at the private sector as a whole, look at what is the net balance of private sector. I believe it is absolutely essential to separate the corporate

sector from households because if household saving goes down, that's good for profits. Yet the total may not change. If households save and profits go down, the total may be, you're missing critical asset because business is going to make the decisions about employment, about investment and so forth. When it comes to, you know, you argue that basically the rising value of assets relative to income pushes down interest rates over the long run. Can you walk us through why exactly that happens? Is it because the central bank is forced to lower rates to support an increasingly

financialized economy every time there's a sign of trouble? Or is it because the actual rising value of assets somehow exerts some sort of force on interest rates itself? It's really what it compels the central bank to do. You know, the general story told by probably the majority of economists for many years, I don't know if it's still, people still even be interested in it, was that the reason interest rates came down during the 80s and 90s was because of falling inflation expectations. The Fed succeeded in lowering people's expectations, therefore there was less inflation.

Interest rates didn't have to be as high. If we look at when the Fed made decisions, it was, they always were raising rates until the, when they thought the economy was strong and inflation was higher than they wanted to be. And they all, but they stopped and reversed when the economy got into trouble. And increasingly, that trouble was financially related. Now, but the real interesting part is what happens when you get into a recession or financial crisis. Each time the Fed had to lower rates further in order to, uh, stabilize financial problems. If we go back to the 1990s when we had the unwinding of the

commercial real estate bubble, we had bi-coaster housing bubbles, we also had a lot of LBO excesses, we were still working through the problems from the savings and loan system, and we had a lot of fallout, a lot of balance sheet problems, overcapacity, things that led the Fed to cut rates, and not just through the recession, but to continue to cut them. for almost another two years before the economy finally showed some life. If we go back to then go into the next cycle when the tech bubble burst, instead of going down to 3% with the Fed funds, right? The Fed had to go all the way down to 1%.

Again, continuing to cut after the recession ended because the economy wasn't responded because of balance sheet problems. And in the latest case, it was clear that they were going to have to go lower. And I say it was clear when I say that. I mean, we went out and I did something I never done before and probably will never do again. I started a small hedge fund to do nothing but play the eventual collapse in interest rates because you knew the Fed would have to go to the floor. Now, our timing wasn't perfect. Fortunately, we ended up doing very well, but I don't want to make sound like I'm too clever because we certainly didn't do, you know, time everything, things lasted longer than we thought.

But the point is, it was clear that the next time there would be even more debt, there would be even more acid value losing it. that the Fed would, and the consequences would require even lower rates, and the Fed was going to run out of room. And therefore, the Fed had to keep rates low for a long time. So sometimes when the stock market starts to fall and suddenly the chatter picks up among various FMC people about rate cuts and people say, aha, there's a Fed put under the market and the Fed only cares about asset prices. And kind of what you're saying is like, that's not even a conspiracy. that's not even that's just how the world has to work these days when unfortunately or fortunately and we don't have to like make any judgments per se but that is just kind of like

the required mechanical operations because the consequences of falling asset prices in a world of gigantic balance sheets more or less leaves the Fed no choice we have to remember the Fed is in a political environment sure my father who was in this business before me met with William Chesney Martin when he was the Fed chair and he said, look, as long as the White House and the Congress disagree about what we should do, we can do anything we want. Implication being, obviously, if everybody thinks you're not doing enough, you better do something. If we think back to earlier in this expansion, why were people pushing for zero rates? Why were they pushing for QE? Why were they pushing for more? Because the economy was not behaving in a satisfactory way.

And people were, we had fiscal stimulus, but it wasn't enough and people were reluctant to use more. So the pressure was on the Fed. And the Fed was their objective is to help get the economy going. So that's what they tried to do. The problem is the Fed really, and I'm really sympathetic to the Fed because they really face an impossible task, although I'm not sure they always realize it, or all members of the open market committee always realize it. And that is that on the one hand, you know, in order to get the economy going, you need to have balance sheets. expand rapidly, especially when they're already this big, and we could talk about why that is, but at the same time, in doing that, they're making the balance is even bigger, creating more

pressures that are going to make things worse. We see this very cutely, it happened in a very rapid time in China, where we saw they would constantly turn to opening the credits big. It's a tremendous debt growth as the economy started to need boosts here and there, and then they began to realize they were creating something that was completely unsustainable, and now they've been back and forth trying to figure out how do they stimulate the economy but not create too big a bubble and they're not doing a really great job of it. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk

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That's vanguard.com slash audio, all investing in subject to risk vanguard marketing corporation distributor. So are negative yields on debts or securities, are those the ultimate expression of this lower interest rate dynamic that you're describing? Because when you think about negative yielding debt, that's something where the only way you're really making money is either through some sort of currency hedging or conversion or by selling it on to someone else, in which case it's capital gains and not income. So is that basically what the world is going to look like if we keep going down this road? Let's start to first talk about the negative policy rates, because that has huge impact. That is critical to having negative yields on bonds. If you are going to lower interest rates and negative rates now, you create a situation where

deposits ultimately they can be either paying fees on their checking accounts or they're going be paying negative interests themselves. And certainly for large depositors, this becomes a big issue. So at some point they say, all right, even if we're not being charged a fee now, if these negative rates become more negative, we will be. So let's lock in a negative rate. So at least we won't, we know how much we're losing. We won't lose as much as we might lose if something else happens. So the expectation of negative short-term interest rates is critical to having negative yields on bonds. If you look at the Great Depression, U.S. when we had deflation, everything else. Yields did not go negative. A couple tiny caveats on that, which were special circumstances,

did not go negative on bonds because people wouldn't take less than zero. They just hold cash otherwise. So the title of this paper, you talk about, is bubble or nothing. The paper details how private sector's swelling balance sheet compel increasingly risky financial behavior. So private sector actors are aware, either directly or implicitly that we live in this balance sheet denominated world in which the only thing that sort of drives the cycle is the direction that asset prices are going in. How does that change the behavior of households and firms? When this is what drives the cycle and how does it compel increasingly risky behavior? All right. We identify nine ways in which the expansion of balance sheet ratios that has higher debt.

income and higher asset to income ratios actually change parameters in the economy that affect decisions. But I'll give you a very graphic illustration of what it looks like first. I won't take it through all nine, don't worry. Go check out the paper if you're listening and read all nine. We have a chart in the paper with data from the, I forget the name of the organization, which the pension fund association. And they show in 1992 that the average target, that is what the manager of that fund is supposed to be achieving on an average over the years, was just over 8%.

At that point, you could get almost 8%, about 7.8%, on a 30-year treasury. Didn't have to be very imaginative taken a lot of risk in order to hit his target. Right. Now, 20 years later, 2012, that target had barely moved, was down slightly, still about 8%. Yet the yield on the 30-year bond was 3%. So now how is he, he can't just say, well, we'll buy some corporate, a investment grade, a little bit higher yield. Now, now they have to think of a whole different set of choices. There was a quote in the IMF making statement that we're having a problem with low interest rates

because too many people are investing in items in assets that are too risky or too illiquid, and this is going to lead to problems. This is exactly the dilemma that comes from balance. Now, again, we talked a little bit about interest rates being forced down as balance rates get bigger and bigger. The crises force the Fed to lower rates to keep things stable. And we also, one of the things that happens is as rates go lower, asset prices go higher. But what's the flip side of that?

low operating rates of return. If you have low operating rates return, the rent on the building relative to the cost of building is low. The dividends or stocks are, you know, the low rate. If you're looking to invest conservatively for income and maybe you'd have a little bit of blue chip equities paying dividends in the past with some investment-crate bonds, now you can't do it that way. You have to depend more in capital gains. So one of the things this does is it puts a lot of people invest in equities who really

want a steady income. And that's, I think, the origin of a lot of the pressure on business managers to meet their quarterly objective for earnings and to put the emphasis there rather than what is good strategically for the long run. I have a question. How do people and I guess companies actually convert capital gains into, you know, wealth or income or something that they can use? Well, for companies, first of all, companies will sometimes have capital gains if they sell assets. In fact, if we look at the period starting the 1980s, we've seen a lot of major capital gains by businesses that it's been a significant part of profits based on IRS data over the decades. But, you know, the most important capital gains are really the ones that are secure by the household sector.

and because how, and those capital gains have become larger and larger relative to income. We've also seen bigger and bigger cyclical swings in the, in assets, so that in other words, the gains, the wealth gain relative to your income over a business cycle has become greater than it was in the past, and your wealth losses during the recession crisis have also become greater. So now, you know, we have another form of instability that, that's, that's, you know, we're impose itself. But wealth effects also affect colleges and private endowed entities where they have their own investments where they have their own capital gains, but also their donations are

largely going to reflect the capital gains of the donors. So, yeah. So on that note, how does asset price inflation actually impact the balance sheet? And I'm actually thinking about corporates here, but there's been a lot of talk that that corporates, It's borrowing from the bond market to fund dividend payouts and also share buybacks has inflated the value of equities. Is that something that you would buy into based on your thesis here? Well, sort of, I mean, those behaviors are clearly happening. The way that we see on the corporation's own balance sheet in terms of its own assets

that we see asset inflation is usually in the form of goodwill, which comes about when they take over, and they do a takeover. They buy a company whose book value is $500 million and they pay $2 billion. Well, the excess goes on as book value, sorry, as goodwill. The most acute places where we see the asset appreciation is, I think, in the household sector, it's also in the real estate, commercial real estate sector, depending, again, which cycle we're in. So let's get back to the original question.

I remember like in the first few years after the financial crisis, 2010 or so. And my thinking, and arguably I would still say it is, is like, wow, that was really bad, but these things come along maybe twice in a century or once in a century. And then typically recessions are nothing like that. But we set up the whole discussion of like, well, can we actually just have this sort of shallow, short, not that bad recessions where there's not really a financial crisis and employment only rises a modest degree. Given what you've said and ignoring about whether we're going to be in a recession this year or next year or the year after that, because that seems hard to predict, how bad could it be?

And are we naive to think that it could just be like a good old-fashioned recession? Well, you know, moving from the principles that are illustrated in this paper to putting on a hat as my day, my normal day job, which is analyzing and forecasting the economy and looking at the world and trying to give opinions about it, what we see is in the United States, the United States was the epicenter of the last financial crisis. It was our housing bubble and the enormous mortgage finance derivative monster sausage machine that we generated. And that had global implications. There were reflections. There were bubbles in other countries, but we were the center of it. This time around the United States is arguably no worse off and in some ways better off than it was going to the last cycle,

but the rest of the world is in much worse condition. And I would say if we had a, there's no perfect analogy, but if I had to pick one thing to say it's this is, this sector's housing bubble, I would say it is the emerging market sector. The emerging market sector has basically their boom over the past generation was largely based on tremendous growth in export. and also tremendous investment in their exporting capacity and infrastructures to support it. These countries were doing wonderfully until they got to be too big a part of the global economy and the developed market economy started to slow down and suddenly they couldn't keep doing this. So we've seen their investment weakening, their exports weakening, and increasingly they've been

depending on incurring debt and basically being kept afloat by the tremendous search for yield that keeps money flowing into risky places. So we think in the next recession, there can be serious problems in emerging markets, flight of capital, and it's going to be a real nasty mess, I think, that will affect the world. So you say that in your view that, you know, perhaps the best analogy to the housing bubble is what's going on in EM. One difference that really jumps out to me, however, is that people were bullish and enthusiastic about housing. certainly still in 2006, maybe even in still 2007, and then suddenly the entire edifice surrounding housing finance seemed to collapse overnight. Whereas with EM, EM assets have been

underperforming world markets for, I don't know, close to a decade now. I think they peaked relative to global markets in 2010 have been underperforming. It's extremely hard to find an EM bull anywhere right now, they'll always say, you've got to look at specific countries or, you know, come up with some other thing they say. And so should this be, I don't know, give us a modicum of comfort? I mean, I'm not looking for comfort, but is it one that there is not a particularly high consensus that these countries are in great shape? It's clearly not a perfect parallel, but I would say that what we've had in terms of the underperformance, but we had the U.S. and Europe, the U.S. with severe problems and then the rest of the world, sorry, Europe in particular with its crisis that it came

out of, at least largely came out of. So we had very rapid recoveries from those things. And the long-term problems I mentioned started to become more and more evident and weigh in the profit growth of those countries. So, but I would maintain that there is still, I mean, even now, there are plenty of people saying this is the time to rotate into the EMS just because they've underperformed. But the main place where the excesses, I would say, is the debt side. The number, the amount of debt that's, you know, the spreads are still historically quite narrow as if there wasn't that much risk there. And yet there's a enormous risk.

Is this private sector hard money debt that mostly concerns you? You mean the, the, the EM private sector or the. private sector dollar denominated. But there's also government. These governments, because of the condition, a lot of them have been able to run deficit spending that they wouldn't be able to otherwise without worry about capital flight or having to raise interest rates or anything else. But also, I want to emphasize, look, we look at Europe. Their debt ratio did not come down the way ours did in the last.

And it's higher than ours. If we look at Canada, they have the highest debt to income ratio in the world. China, very close. Australia are close, South Korea is close. So we have a lot of countries that have excessive balance sheets in one way, the other. It's more mixed. It's not like in some sense the housing bubble in the U.S. was like, it was a kind of a pinnacle. But there are plenty of problems.

And the thing is, the United States has the institutions to contain the damage, to stabilize this banking system. When we have a crisis, actually our currency strengthens. Right. That's not, it'll be a very different situation, I think, for emerging markets, and that's, that's why that's concerned. I have a step back question, I guess. Our previous guest on Oddlots was Richard Koo from the Namorra Research Institute, and he's famous for coming up with the balance sheet recession idea, which is that basically after, you know, we get big recessions, it's very, very hard to get the private sector to lend again. People are sort of scarred by the experience. And even if, you know, we get a big recession, it's very, it's very hard to get the private sector to lend again. People are sort of scarred by the experience. And even if, even if interest rates go lower, they're not necessarily willing to go out and borrow. But you're sort of saying the opposite here. You're sort of saying that the reflexive reaction is to continuously go out and expand your balance sheet.

Why do you think, how do you account for that difference? Well, first of all, let's talk about who's expanding their balance sheets. We're not seeing businesses go out and invest to expand capacity. the economy is not really, the private sector is not investing and the profit sources are staying depressed, where the money is being borrowed is in the financial sector, people are trying to leverage positions to try to get more returns. I mean, there's always, you know, there's borrowing in parts of the world going on, they're emerging markets, there are corporations who are in trouble who would be cutting back,

but they keep borrowing to keep themselves afloat. Let me also just say generally, because, you know, Richard Koo really did a brilliant thing. Coming from a conventional background, he looked at the situation and in Japan and said, wait a minute, there's something going on here that is not being accounted for. And he very properly identified the bubble as having created over-extended balance sheets, and the process of bringing those balance sheets down was having all kinds of economic as well as just pure financial market effects. And a lot of his policy prescriptions, I agree with not perfectly, but very much.

large extent. But it's important to think that balance sheets play a role in their expansion and their contraction plays a role in the economy throughout history and that the balance sheets have had, there's a long story here. This growth in balance sheets relative to income has made it possible, not only made it possible, we get to the point of we have these bubbles, but it started to generate its own pressures once you get to a certain point to create bigger and bigger bubbles each time until the whole thing breaks down. So, whether it's Richard Koo, many of the sort of MMT post-Kanesians, leftish economics types, and increasingly mainstream new Keynesian types like Larry Summers, there is this growing consensus

that to break this cycle that you described of lower and lower rates and more and more bloated private sector balance sheets and mediocre growth, what we really need is for all the developed market governments to step up and do true fiscal stimulus, really unleash fiscal firepower. And of course, we know that it's politically difficult because of politics. But in theory, that's what could break this cycle. Is that, do you agree with that? Is that ultimately what could break this cycle of larger and larger, riskier balance sheets, is if essentially more and more of the debt, we're not at the household sector, not at the corporate sector, not in financial leverage, but in direct government spending, which is largely risk-free so that the debt swapped from risky private debt to largely risk-free government sector debt,

which is basically a safe asset. And if that were done in a concerted large-scale, sustained manner, would that break the bubble-or-nothing cycle that you describe? Here's the tricky part about it. The tricky part is if the vision is that we get the whole global. economy to be growing in a lovely manner supported by fiscal policy and somehow these balance sheet excesses will just fade away. No, they won't. As long as the economy is prosperous, people are going to try to figure out how do we get higher returns? And if they're not there, now one of the things that happens is if you raise interest rates, you tend to bring the asset values down,

but the negative wealth effects will be very powerful. The reality is governments are reactive. They're not pre, you know, they're not going to come up with a, you know, a great, great move ahead of time. And I think what we're likely to see is in the next recession. We will see reliance on fiscal stimulus to, and hopefully associated with long-term investment and doing things that government has been neglecting in many places anyway. We have a whole lot of technology changes to make. We have to adapt to changes in how we use and create energy. So there's a lot of positive things that could lead to a boom down the road. But I think you cannot escape the fact that the correction is not going to be easy.

People don't like to have their wealth go down. And in some sense, you know, we have created a fantasy with great market enthusiasm and extremely low interest rates that somehow assets have an enormous value relative to the income they produce, which is just not really going to be sustainable. We're just screwed. No, look, this is not the end of the world, but I, you know, I think we're going to go through some, some bumpy cycles. And there will be, I think I am worried about certain parts of the world that do not have the ability to stabilize themselves. But I think for the, for the U.S., hopefully we won't go through a recession as bad as the last one, but there are going to be some bumps. So just to be clear, though, can we ever go back to a 1950s world in which the economy cycles are not driven by asset prices but are driven by income and production? Well, I think we are in all probability headed exactly to that.

But I think we have to go through the corrective process. That corrective process means that we need to go through a pier where asset prices are going to come down, home prices have to come down. If you look at Robert Schiller's chart on the very long-term real home prices, you see that we had a lot of stability for throughout history, this enormous spike in the last cycle. We came down just back to the old highs, and we went up not as big a spike, but they're still just too high. We need to adjust that. Equity valuations have to be adjusted. That's going to be difficult.

But by the time we come out of this and this long period of weak investment, the need to reinvest, the new technologies, the pressures, I think we're going to come out of it. But we probably have to be a little bit like the Phoenix. We may have to catch fire a little bit before we rebirth. But not, that's probably the wrong analogy. That's too extreme. I think in Japan, although it took them longer and they didn't do everything right, they did avoid a great depression.

And I think they've healed a lot of their problems. What's your one recommendation to either politicians or policymakers about how to handle the big balance sheet issue and actually map? manage us into a place that is more similar to, you know, the 1950s style of recession? Well, number one, there's no easy, clear roadmap, but here are four very quick rules. Number one, when you need to stimulate the economy, rely more on fiscal policy, hopefully for public investment. Number two, don't let the banking system break down.

I think most of them get that, but keep it functioning. You can, you know, make the stockholders and the manager, you can punish them, but keep the banking system functioning. Number three is encouraged orderly working out of problems when they're there. Resolution Trust Corporation for the Safe As a Loans is a great example. And the final one is try to avoid, and this is the real tricky one, doing things like extreme monetary policies that might lead to reinflating asset bubbles at a time you don't really want to be doing that. David Levy, this was a fascinating conversation. And even though it's kind of depressing because you would have hoped that maybe 2008, 2009 would have been that Phoenix moment.

I do appreciate that you left us on a little bit of hope that we're not all going to die. I think over the next generation, we're going to see wonderful revival. I could go a whole laundry list of reasons why I think the U.S. has got a very bright future. Manufacturing coming back, all sorts of things, having nothing. A trend that's already begun actually long ago. It's not all doom and gloom. It's not all doom and gloom. But time for being a little cautious.

Definitely. All right. Well, really appreciate you joining on. I highly recommend everyone read your port. And if you don't read it, just check out the charts. They're great. So thank you very much. Thank you, Joe. Thanks, David. Joe, I found that conversation really, really fascinating, not least because I personally have been thinking a lot about the financialization of the economy. Though I think about it mostly in relation to corporates. And I sort of alluded to it in the conversation, but M&A and buybacks and how that's interacted with asset value. But I really liked David's separation of corporate versus household versus government leverage.

Like we tend to think of leverage as this one big cohesive concept, but it actually has different effects on the economy, of course. Yeah, I think financial media can often get extremely lazy about using the word debt. And it's like, oh, there's a lot of debt out there without. We are the financial media. No, not us. Not me and you, other people. but other people, and it is really important to distinguish between different kinds of debt, what's risky, what's productive, what is going to be a burden on the economy. And I just want to say, like, I really, I don't think we intended it, but some of these last few episodes, I'm really into this balance sheet theme because we're, of course, talking to Michael Pettis and the structure of Chinese balance sheets, Richard Koo, talking about the balance sheet recession where he sees it today. And then obviously, getting more granular with David about different aspects of private sector balance sheets and

the sort of ever-inflating bubble. This feels like a really meaty topic and one that the mainstream is only now just starting to really come around and appreciate it. And like I said, you know, it's not totally outside the mainstream. I think Jerome Powell hit on a couple of these things and Jackson Hole a couple of years ago. But I'm bullish on this as a topic. Well, a lot of these ideas sort of exist in the public sphere. I mean, David mentioned the IMF report talking about, you know, risky practices spurred on by low interest rates. They're all sort of out there. But what's nice about David's paper and his thesis is that it all kind of pulls it together in a really tangible way.

And we've actually inadvertently created a balance sheet series, which is quite cool. We have. We have three. Three is a trend. Yeah. Three's a trend. All right. On that note.

All right. has been another episode of the Oddlots podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart. And you should definitely check out David's paper, the bubble or nothing, how private sector's swelling balance sheets compel increasingly risky financial behavior. Really fascinating stuff. And be sure to follow our producer on Twitter, Laura Carlson, at Laura M. Carlson. And all the Bloomberg Podcasts under the handle at Podcasts. Thanks for listening.

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