Let This River Flow

The law of diminishing returns means that even the most beneficial principle will become harmful if carried far enough. – Thomas Sowell

The Marshall Plan, formally known as the European Recovery Program (ERP), was an initiative in the aftermath of World War II designed to address the widespread devastation and economic upheaval Western European nations faced. Introduced on June 5, 1947, and named after US Secretary of State George C. Marshall, the plan provided economic assistance from the US for the reconstruction of war-torn Europe.

To prevent the spread of communism and foster stability, the Marshall Plan was enacted through the Economic Cooperation Act of 1948, allocating financial aid to Western European countries. Over the program's four years, from 1948 to 1952, the United States contributed approximately $13 billion in economic and technical assistance. The plan's scope encompassed many sectors, including infrastructure, industry, agriculture, and trade, providing grants, loans, and technical expertise to support economic recovery.

Many funds were directed toward rebuilding war-damaged infrastructure, such as transportation networks, communication systems, and industrial facilities. It’s claimed that this strategic investment played a crucial role in restoring economic productivity and fostering job creation.

The legacy of the Marshall Plan persists as a widely acclaimed success, credited with fostering economic recovery, ensuring political stability, and promoting democratic governance in Western Europe. However, contrary to prevailing beliefs, a closer examination suggests that the Marshall Plan did not confer as much benefit on Europe's economies as commonly thought. Moreover, the correlation between Europe's economic revival and the allocated dollars may not have been causative.

Firstly, the implementation of the Marshall Plan coincided with the restoration of free-market economic structures, marking the end of a period dominated by government-controlled and organized war economies. The resurgence of the free market likely played a pivotal role in Europe's recovery.

Secondly, if the money provided through the Marshall Plan played a significant role in economic recovery, the UK, having received more aid than other European states (twice as much as West Germany, for example), should have experienced a superior recovery.

Thirdly, the economies had already rebounded in certain countries like France, West Germany, and Italy before receiving any Marshall funds. In these cases, one might argue that the aid provided an additional boost to the recovery. Nevertheless, as D.W. Mackenzie suggests, the aid West Germany received was relatively small compared to its Gross Domestic Product, making it less likely that the Marshall Plan played a significant role.

Adding skepticism to the claim that the Marshall Plan revitalized Europe is that, according to Tom Woods, the countries that received the highest amount of aid per capita, such as Austria and Greece, did not recover until the Marshall Plan was phased out.

Moreover, the economic principle of diminishing marginal returns, recognized since Adam Smith's "Wealth of Nations" in 1776, suggests that additional units of a variable input, like money, used in conjunction with other relatively fixed factors of production, yield diminishing returns. Therefore, while additional spending might initially boost GDP, it can eventually burden the economy.

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This is a crucial consideration in ongoing discussions about the economy's future trajectory, whether Western economies will sustain growth this year, and whether policymakers can truly achieve a "soft landing" or even avoid a landing altogether.

While the prevailing narrative asserts that a soft landing has already been achieved, it's worth noting that the soft landing narrative is not a novel concept. In March 1999, the majority of economists similarly anticipated a soft landing:

The survey, released Tuesday by the National Association for Business Economics, ruled out the prospect of a U.S. recession before 2001. Instead, the survey said the economists expect U.S. growth to slow gradually as consumer spending cools. By 2000, the growth rate should be 2.3%, the survey said.

About a year later, in June of 2000, the Washington Post penned:

Confidence in the "soft landing" stems from the current boom--which has consistently defied pessimists--and a fervent faith in Greenspan. His record surely warrants respect. The economic expansion, now in its 10th year and the longest in U.S. history, has already experienced one "soft landing." Between February 1994 and February 1995, the Fed funds rate went from 3 percent to 6 percent. Some economists feared a recession. It never came.

These old news sound remarkably familiar to what one reads in the financial media today:

...the managing director of the IMF, forecasts a soft landing for the US economy in 2024, akin to the successful soft landing witnessed in the mid-1990s. This forecast underscores the US economy’s resilience and its ability to avert falling into a recession, which, in turn, may result in positive gains in the stock market, as historically observed during successful soft landings.

Yet, the prospect of a soft landing looked much more compelling in 1999/2000 than today. Now and then, the US nominal GDP grows 7 % year-over-year. Still, there is a fundamental difference: In 1999/2000, the US government ran a budget surplus as the economy grew, while today, the US government runs a rolling deficit of 7% of GDP. This means that before the dot-com bust, the US government benefited from economic growth through higher tax revenues, whereas it is now running deficits to keep GDP high.

Interestingly, the fiscal deficit as a percentage of GDP usually only exceeds nominal GDP growth when the US economy experiences a recession. Nominal growth stalls as the economy is going into recession and governments increase deficit spending to fight it.

While the US economy is still growing at a nominal rate of 7%, the debt-to-GDP ratio has increased slightly. Moreover, when US deficits surpass nominal GDP growth rates, government debt/GDP spikes, as observed sharply in 2009 and 2020 during the pandemic.

However, the tides have turned, with deficits rising while interest rates are off their multi-decade lows. After interest rates peaked in 1980, governments started running higher deficits due to decreasing interest rate expenses. Whenever their debt matured, they could issue more at a lower rate.

On the other hand, businesses could lower their debt burden, as they could borrow at lower rates, and additionally, their assets increased in value. The deleveraging of the private sector is, therefore, a direct consequence of the interest rate policies of central banks over the last four decades.

As the COVID pandemic unleashed the final wave of massive money printing that found its way into the real economy through a spiking government deficit, the claim that inflation was primarily a supply-chain issue seems a bit odd. World manufacturing output fell by 2.88% in 2020, increased by 17.16% in 2021, and increased by 2.33% in 2022.

This benefited big businesses that borrowed long-term at low rates and then from higher cash rates as central banks raised interest rates. Big corporations and institutional investors are those who earn enough interest to refinance. This money has flowed back into financial markets and helped push equity markets to new highs.

Consumers also kept going due to various factors: falling inflation helped raise consumer confidence, as it improved real wages, and the inflationary spike inflated a part of their household debt away. That is the reason why the recession in 2023 never arrived and surprised everyone.

However, should we now expect that policymakers succeeded in creating a soft landing, as the majority thinks, or are people like Jim Bianco, Joseph Wang, or Nicholas Glinsman correct when they argue that the economy will continue to surprise everyone in 2024, which will crush bonds further? Better-than-expected economic data and recent comments by central bankers have pushed rates back up after markets cut back on their rate-cut bets. This seems to support the view of the no-landing crowd, especially if real growth remains strong and the job market resilient.

The core of their assumption is that inflation will find a bottom at the current 3%, either settle here, or start to rise again because the economy has changed and can now handle interest rates this high and that they are not nearly as restrictive as they seem.

A central part of the argument is that interest rates empirically follow nominal GDP growth, as pointed out by Professor Werner. Using this logic, as nominal GDP is still running at around 6%, the conclusion is that the US 10-year yield should settle somewhere around 6%, with real growth around 2% and CPI around 3-4%.

However, what is neglected here is that nominal growth follows changes in the quantity of money. With a lag of one year, changes in the money supply can explain changes in nominal GDP with a correlation of 25%. Logically, money supply growth pushes inflation upward, increasing nominal growth and increasing nominal interest rates.

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Obviously, other factors also influence nominal growth, such as productivity growth or an increase in the labor force. However, given that nominal growth equals real growth plus inflation, I would argue that changes in the money supply play a role here. As of the end of 2023, US M2 contracted by 2.95% year-over-year, suggesting that despite the latest uptick, consumer price disinflation will continue, and thus nominal growth will follow.

While CPI could potentially be higher in the coming months, I would suggest it's more related to imbalances resulting from geopolitical turbulences and wrong expectations of economic actors, as I wrote last week. Time will tell whether short-term price increases are sustainable, and with the fall in the quantity of money, one either needs to see a fall in money demand or a falling supply.

However, if one assumes that supply will contract, that would contradict the no-landing narrative, and thus it can be dismissed. Falling money demand, on the other hand, could be discussed, as it would translate into higher CPI but falling prices of financial assets, which are more “money-like,” if you will. Yet, the worst-performing asset class in the previous years has been bonds and bills. However, the sell-off was not driven by falling money demand but by inflationary pressures that pushed interest rates up and, hence, bond prices down.

Now, as it seems clear that the peak in interest rates is reached, the question remains when central banks will start to cut interest rates and by how much. This week, Fed governor Christopher Waller gave a speech that basically repeated what various Fed members have said recently but added that he is backing the latest Fed dot-plot of three rate cuts this year and that the market is too aggressive when it prices six.

Meanwhile, Christine Lagarde delivered a speech in Davos echoing sentiments akin to those expressed by Waller concerning the ECB and its prospective trajectory for interest rates. For now, I'd expect that the sell-off in bonds might continue for a little more as long as positioning remains bullish, economic data remains where it is, and the next CPI doesn't surprise on the downside.

Nevertheless, if it does, it shouldn't be seen as a sign of strength but rather as a sign of weakness because it translates into bad news for government deficits, and not only in the US, as it means that nominal GDP is falling while the deficit keeps growing, potentially pushing interest rates higher.

Higher rates would be bearish for the real economy as many companies have to refinance at much higher rates this year while the latest monetary tightening still becomes effective. It can be expected that the private sector will not invest as much as in prior years and will probably continue to deleverage for as long as possible.

Previously, government spending has made up for that, crowding out private investment in the economy. However, the marginal revenue product of government debt is already below one, and thus, the notion that more government spending can secure a no-landing in 2024 is doubtful.

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So, what about the soft landing currently celebrated by US government officials and progressive-leaning economists? The major arguments here are that unemployment is still at record lows, the economy is experiencing robust growth, real wages are on the rise, and financial wealth is better than ever; hence, the narrative suggests the economy is far from entering a recession. Does this evidence prove that a downturn is avoidable and the landing will be soft as long as the Federal Reserve cuts interest rates? I would argue against that for several reasons.

First and foremost, indicators such as personal income, unemployment, and economic growth are poor predictors of a recession. They typically only show signs of breaking down when the recession is already underway. Furthermore, the assumption that higher wage growth can induce a wage-price spiral that elevates future CPI is flawed. Empirical evidence is thin, suggesting that it's more likely that inflation can explain future wage increases.

This is also consistent with wages and unemployment being among the last indicators to react when a recession is already in progress. Consider a scenario where a rise in the money supply increases demand for goods and services, leading to higher prices. As businesses observe these price increases, they raise their prices.

As long as demand remains at expected levels, this raises profit margins, a point also noted by Isabella Weber. However, falsely concluding that rising profit margins cause inflation is an error. As inflation unfolds and workers experience real wage losses, they begin bargaining for higher wages to catch up with inflation. This process compresses profit margins until companies start laying off workers.

A recent example is Delta Airlines, which lowered its profit goal for 2024 due to elevated cost increases, including higher wages. With inflation falling but real costs rising, increased layoff announcements might continue, leading to higher unemployment in the coming months.

When comparing real personal income, real GDP, or the unemployment rate to those before previous recessions, none are at unusual levels. These indicators lack predictive power regarding the occurrence of a recession. Now that very few expect a hard landing, it's probably not as distant as believed.

All these factors point to a hard landing, significantly if central banks don't reverse course, and falling nominal GDP pushes debt/GDP ratios back up as governments continue to run deficits, potentially driving yields higher. I would still assume that Europe must cut rates first, driving EUR/USD lower.

While I hold a positive outlook on short-term bonds, given their limited downside, long-term bonds might see further declines before reaching their lowest point.  However, this time, the potential for gains may be restricted as central banks begin inflating government debt to counter inflation, anticipated in 2025.

Who will rise and return from sleep (Give me strength to run)
Become one with the remedy,
No regrets, no compromise, story will be told,
won't reject the cure this time, let this river flow

Soilwork – Let This River Flow

Have a great weekend!

Fabian Wintersberger

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(Please note that all posts reflect my personal opinions and do not represent the views of any individuals, institutions, or organizations I may or may not be professionally or personally affiliated with. They do not constitute investment advice, and my perspective may change in response to evolving facts.)