How To Evaluate True Macro Risk? ft. Philipp Carlsson-Szlezak

[00:00:07] Philipp

So, I think it’s sort of a reminder of how hard it is to do this, which doesn’t mean it won’t happen. It will happen. Just we got to be realistic about the timing and the sizing of this.

When I when I see these stories of GDP growth that it’s going to go up more than a percentage point. No, it won’t. Not next year, not the year after.

Cumulatively, this will be powerful. But let’s just stay realistic is the message of the book.

[00:00:35] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

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Here’s your host, veteran hedge fund manager Niels Kaastrup-Larsen.

[00:01:30] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary people from all around the world. In this series, I have invited one of them, namely Kevin Coldiron, to host a series of in-depth conversations to help uncover and explain new ideas to make you a better investor. In the series, Kevin will be speaking to authors of new books and research papers to better understand the global economy and the dynamics that shape it so that we can all successfully navigate the challenges within it.

And with that, please welcome Kevin Coldiron.

[00:02:07] Kevin

OK, thanks, Niels, and welcome, everyone. So, in early August, the world economy was hit with a shock: the sudden unwinding of the massive yen carry trade, which for a time spilled over to other markets, including the US stock market, and it felt like maybe it was going to morph into a financial crisis. But in the end, markets settled down pretty quickly and it turned out to be a false alarm. So how do we evaluate true macroeconomic risks in a world that’s regularly hit with these kinds of events?

Well, our guest today is Philipp Carlsson-Szlezak. He’s the chief global economist at BCG and author of a new book that has that exact purpose. It’s called Shocks, Crises and False Alarms: How to Assess True Macroeconomic Risk. And Philipp’s here today to explain his framework and help us think about and navigate macro risks in the future. So, Phil, thanks so much for joining us and welcome to the show. Thank you.

[00:03:07] Philipp

It’s great to be with you.

[00:03:09] Kevin

OK, well, you start and end the book with a quote from Voltaire. “Doubt is not a pleasant condition, but certainty is an absurd one.” And I get the feeling that you that you feel forecasts of economic doom fall into that latter category of absurd certainty. And I wanted to ask, is that right? And how much of that maybe was a motivation for you to write this book?

[00:03:45] Philipp

Yeah, it’s nice that you picked up on the Voltaire quote. Look, the contention here is that there is too much doom saying, but also constant point forecasts to rate the future. Why are we doing these point forecasts that usually fail? Well, because uncertainty is so uncomfortable. So, we’re throwing everything we’ve got at uncertainty to try to minimize it. But in the end, the argument of the book is it’s futile.

There will be shocks. There will be situations that you fail to forecast. In fact, most of them you fail to forecast. And so, it’s better to get comfortable with uncertainty, a bit like Voltaire phrased it.

So, I think that is sort of the background of that quote. While we snuck it in, I think in two or three places. I think the bigger theme of the book is that we live with public discourse on the macro economy that is decidedly negative and skewed to the downside.

The airwaves are dominated by doomsayers who predict the end of times regularly. They’re given a lot of space in public discourse. And when you just think about the last few years, yes, there were a lot of gyrations, a lot of volatility we had to put up with. But actually, you know, the economy has held up really, really well. And so, the book is a contribution to trying to sort out these discrepancies.

[00:05:04] Kevin

Yeah, you say, I think at one point that, you know, financial journalists can’t write about sex scandals. So, the next best thing is economic doom.

OK, so you have a framework for macroeconomic risk assessment, and it involves three habits. One is rejecting kind of what you call master models of the economy. Another one is what we just talked about, skepticism about doom mongering. And then the third one was what you call eclecticism.

I feel like the first two are fairly straightforward, but I’m curious, maybe you could explain a little bit more about that third part. What do you mean by eclecticism?

[00:05:46] Philipp

Yeah, eclecticism, in the end, is just a fancy word for multi-disciplinarity, looking past the confines of your own discipline, which for economists is really important. We make the case that economics is not a great soloist, but it plays well in a band. So, you want to bring in adjacent disciplines to broaden the analytical canvas you paint on.

Economic eclecticism, the way we lay it out early in the book, is essentially being very, very cognizant of historical context of political economy, certainly finances or finance angles in our book. But you can go further afield. There’s almost nothing that doesn’t impact economic analysis.

We warn against treating economics as a natural science. And we’re not the first ones to do that by far, much, much, much more influential and famous economists than ourselves (when I say ourselves, I mean, Paul Swartz, my co-author and myself), more famous and influential economists than ourselves have made this point.

People have forgotten about it. But von Mises, from the Austrian school, he did not like the idea that we treat economics as a natural science because the relationships are inconstant the way they are in the physical world. Keynes made much the same point.

And Hayek, he really had the greatest way of, of making that criticism when he was awarded the Nobel prize in 1974. I think we have that anecdote in the book. Maybe it was demoted to a footnote, but it’s a worthwhile anecdote.

When he was awarded the Nobel prize in ‘74, he uses his dinner speech to essentially say, look, you should not have come up with this prize in economics, and if you had asked me, I would have advised you against it. He says that if you do, you should ask all recipients to swear an oath of humility.

Why humility? Because he foresaw the tendency of economists to pontificate on everything way outside their field of expertise. The way that recipients of the prize in chemistry or physics typically don’t, there’s something about economics that kind of radiates into everything.

Somehow influential economists think they have a license to pass judgment on absolutely everything. And I’m not going to name names, but it’s not hard to imagine some of the protagonists of that craft who will use their economics perch to explain the world on absolutely every angle. So, a broad answer to your question, but essentially eclecticism is our reminder that economics cannot be reduced to a physics like science.

You will need to do adjacent analysis. You will need to bring in a lot of the softer aspects of how politics works and how political economy works. And that’s what eclecticism refers to.

[00:08:44] Kevin

In some sense it’s the beauty of economics. In fact, I think when you re-quote Voltaire at the end of the book, you say, “What’s so bad about uncertainty anyway?” It means that it’s kind of challenging and fun to kind of figure out how the world’s going to operate.

If I could just loop back to that second point about doom mongering. What do we do when we’re confronted with a doomsayer on the street? I mean, you know, how do we react?

What questions should we ask ourselves in order to evaluate a forecast of economic doom, economic crisis when you have some, I guess, points that you say rational actors will kind of say to themselves when confronted? I think that that’s an important thing for listeners out there. Like you say, we are confronted with those forecasts a lot. What’s the proper response? How do we take a breath and what questions do we ask ourselves?

[00:09:40] Philipp

Yeah, that’s a great question. Let me say first, I don’t usually encounter them in the street. I mostly encounter them on financial news programs on TV or in the headlines.

The best response that we talk about in the book is to not focus on, will something happen and, how bad will it be and how soon will it happen. Ask the doomsayers what is it causally coherent narrative that actually gets us there?

Don’t talk about the outcome. Don’t tell us how big your probabilities are for it and your odds. Tell us the drivers of how we get to the edge of whatever situation you’re forecasting.

Typically, what turns out is that we’re jumping to conclusions. We’re jumping to the edge of the risk distribution. What doomsaying discourse does is that it talks about valid, if long shot risks, from the edges of that risk distribution, and it pulls it to the very center and passes it off as the base case.

That is typically how a lot of conversation happens on financial TV. That’s how a lot of headlines come together. It’s not that these risks are not valid or impossible. They are.
The book is, is very cognizant of very, very significant and systemic risks. But we don’t serve anyone, at least ourselves, if we pretend those risks to be at the center of the distribution, when, in fact, they mostly live on the edges of that distribution.

[00:11:17] Kevin

I gotcha.

I think you mentioned a specific example of a false alarm, during COVID, that impacted, if I’m right, the car industry, the auto industry. I might’ve got that wrong, but could you maybe walk us through how that false alarm, maybe assuming the worst case scenario, ended up backfiring on firms, going into COVID and coming out of it.

[00:11:47] Philipp

Yeah. We just have to do a little time travel, just four short years, a little more. So, in March and April of 2020, when COVID hit, it was admittedly a very difficult situation to read. That said, the outcome was not a foregone conclusion in terms of how swift or how bad a recovery would be. Nonetheless, conventional wisdom, public discourse really zoomed in on the worst and longest recovery you can imagine.

So, the conventional wisdom was worse than 2008, maybe as bad as the great depression of the 1930s. Right? And typically, just to quote one common perspective off the top of my head, I think it was Rogoff who came out and said this would take six years, among many others.

So, we jumped to conclusions about what is the nature of that recovery? Doing so was a false alarm. It was the tightest and fastest recovery on record. It was also a recovery that left no structural damage to the US economy in the sense that output is now higher, in 2024, than was predicted for 2024 before COVID hit. So, we were now above the trend line that predates COVID if you will.

Falling for that false alarm was costly for some, many. And you mentioned the automakers. Yes, we do have that as an example in the book. Many took that at face value.

So, what did they do? Many automakers canceled their semiconductor orders. So, they went to the back of the line when, instead of a really long recovery time, they got this very aggressive recovery with spiking demand for automobiles. And so, they didn’t have the semiconductors that power their cars.

We essentially landed in a world of bottlenecked auto production, price spikes. You remember all that. And we use it as an example of how tangible such damage can be if you read the macro environment in a too gloomy light, or if you jump to conclusions and you don’t allow for a more eclectic reading of the situation.

I will add one thing, Kevin. So, our own predictions at the time, even in March, 2020 (and we did a big, long piece in the Harvard business review at the time), we said, look, don’t jump to conclusions. We asked exactly the question, what does it take for a really bad recovery that lasts many years?

What does it take? What are the coherent drivers that make for a poor recovery? And we walked through those drivers, and we concluded, in March, 2020, well, that can happen, but it’s not our base case. And we pointed to the power of policy innovation and the policy space, the ability and willingness of policy to act. And we remained essentially on a very optimistic line there, saying don’t run and embrace the 1930 scenario. We’ll have to see how policy plays out. And I think that was a better stance to take with hindsight and at the time.

[00:15:05] Kevin

Well, thanks for that. I think that story really brings it home and it’s still fresh in a lot of our minds, fresh enough that it really resonates.

I wanted to talk, maybe about some of the key macro risks we’re going to face going forward and try to use your framework to help us think about that. The foundation for, it seems like, a lot of you are thinking about the macro environment going forward is what you call a new era of tightness. I was wondering if we could just start with explaining that idea to the listeners. What do you mean when you say we’re living in a world of tightness, an era of tightness?

[00:15:49] Philipp

The era of tightness refers predominantly to the labor markets. And it is a misconception that tight labor markets are a by-product of COVID. It’s not true.

So, the tight labor markets set in, in 2017, around three years before COVID. What is tightness in macro jargon? It’s when the unemployment rate drops below a so-called neutral rate of unemployment, essentially labor is quite scarce.

That happened in the few years before COVID. It comes with a lot of good things, including wage growth, particularly at the bottom of the distribution, and such things. But our bigger theme here is we’re essentially in an era of tightness that predates COVID.

COVID interrupted it. So, unemployment shot up to almost 14%, thereabouts, and then it came down almost as fast as it had come up. So, COVID was an interruption.

You went back to this tight stance in the labor market. COVID exacerbated it. And what we’re saying is an era of tightness kind of lasts unless it’s interrupted by a big reset, like a big recession or a financial crisis, something that introduces structural slack in the labor market: a big amount of unemployment that takes a long time to bring down, such as after 2008. Unless you get that kind of interruption, an era of tightness is kind of self-reinforcing.

So, even when you get the next recession, and you will get another recession, we think that even after such a next recession, you will come back to tightness. So, the labor market will remain tight.

Why is this essentially a good thing? I mentioned one, it’s a tailwind to real wage growth, particularly at the bottom, but generally when farms can’t hire the labor they want, or at the price point they think they can afford. They’re first nudged and later forced to embrace technology and that moves their production functions to the frontier, or the technological frontier. And that leads to incrementally better productivity gains. And that is beneficial to the economy as a whole.

There are other things in there, but in a nutshell, we think an era of tightness is a positive thing. And historically it would demonstrate that eras of tightness have been big tailwinds to the macro economy. That’s how we think about the 2020s. Time will tell if this is a good call, we feel pretty good about it, and we’ll see if it pans out that way.

[00:18:27] Kevin

Thanks for that explanation. And that really maps into this notion of… We’ve had a number of guests on the show. Our last guest was Mark Mills. We’ve also had Peter Oppenheimer, all are saying, in one form or another, hey, productivity growth is going to increase and that’s going to be good for growth. They have different takes on when and why.

You’ve got a chapter that is titled When Technology Lifts Growth and When It Doesn’t. And you just mentioned that, and I think it’s so important that we ought to repeat it. You basically said big productivity boosts are not about coming up with new products, but it’s coming up with labor cost reduction at scale. Can you just explain why that’s the case; why product innovation isn’t so important and why it’s labor cost that matters and why that might be the world we’re in now.

[00:19:31] Philipp

We’ve observed, over many years, that technology and productivity growth is often framed and viewed through the lens of product innovation and, what we call in the book, snazzy apps. And that’s why we use Uber and Lyft and the likes as an example to make our case.

So, Uber is a really cool app. It’s snazzy. It’s a very expensive app. It took a lot of money to develop it and get Uber off the ground. The bigger question is, is Uber a productivity enhancing app? And the answer has got to be no.

When you compare an Uber ride to a classic taxi ride, there’s no productivity gain. Why? Because the production function is unchanged. You still need the same labor, and you need the same capital input: the car. So, there’s a little bit of better matching of drivers and riders, and that has been studied. They’re modest. Keep in mind, Uber rides are more expensive, across the board. So, if you have real productivity gains, the rides will be cheaper, not more expensive.

The point here is, if you can replace the driver then we’re talking about productivity gain. So, we’ve reduced the cost at scale. And of course, that promise has been around for a long time: the driverless car, the driverless taxis. I’m not holding my breath to see those on the streets of New York in the next few years. It will be a long time.

I think that will happen and we’ll make slow inroads. And this is an incremental gain, and somebody will find a formula that is successful. And that will be creative over the medium and longer term. But this kind of stuff is way behind schedule relative to promises and a lot of the hype that was out there. That’s why you don’t see these rapid shifts in productivity growth. You’re going to have to cut out a lot of labor to reduce costs.

I want to make two more points on that, Kevin, if I may. The first one is that we think that tight labor markets are so important in this era of tightness. Why? Because technology is the fuel for productivity growth, but tight labor markets are the spark.

If you can easily hire labor, as you did in the 2010s, why do CapEx? If you write the next chapter of growth by hiring readily available labor, and labor that is at a good price, you’re going to do that. You did no CapEx or little CapEx in the 2010s. When the labor market is tight and you can’t find the people or you can’t find them at the price that’s good for you, well, then that’s where tight labor markets are the spark that leads you to actually use the fuel of technology. You’re going to do that.

The other point I’d like to make is we don’t view the displacement of labor from technology, through technology. We don’t view that as leading into a world without work. Generally, the sort of technological unemployment narrative. we look at that very unfavorably. History is full of such predictions. All of them have failed.

The idea that technology leads to job losses is certainly correct. But the bigger theme, across more than a hundred years, has been that because technology allows you to lower costs (that’s how you get productivity gains), prices also tend to fall.

So, technology is deflationary. When I lower my prices to grab your market share, what happens? The real income of consumers rises. So, they consume other things (new services, new goods), and that creates new employment in goods and services (predominantly services) going forward.

Essentially, this is the whole cascade of thought in the book; big macro productivity shifts comes when technology credibly reduces a lot of labor inputs. We’re not quite there yet at scale. It will take more time, be more incremental and tight labor markets will help that, overall. And we don’t believe in the technological mass unemployment story. So that’s the full cascade of thought there.

[00:23:47] Kevin

Yeah. Those are really important points. And I thought you made that very clear in the book.

Just to repeat what you’re saying is, number one, firms, in some sense, have to be forced to adopt new productivity as a new technology, and they’re forced via the tight labor markets. So, you need both the technology and the tightness, number one.

Number two is that yes, the productivity growth comes from replacing labor. So those people, in some sense, if your job is replaced, obviously your incomes go down. But over overall, across the economy, what you’re saying is prices fall, so incomes rise. People have extra money in their pockets, and they spend it on other stuff. And that other stuff creates businesses, sectors, jobs that didn’t exist before.

So, have I got that right?

[00:24:43] Philipp

Absolutely. And let me recite the example that I think we use on the book. I hope we do. We use it all the time. I think it’s on the book.

Once upon a time, I think we use 1870 as a starting point, most people, or something like 45% of the population, work on a farm in the United States. Everyone’s in agriculture and Americans spend more than 40% of their budget on food. That’s important.

And then successive waves of technology lead to less than 1% of Americans, or around 1% of Americans working in agriculture. But importantly, we only spend around, I don’t know, 11%, 12% of our budgets on food. So, because technology has been very deflationary in food, it has freed up a lot of income.

So, we went from more than 40% of our budgets spent on food to just, you know, over 10%. What has happened with the gain of 30 percentage points of budget? Well, it’s gone on everything else consumed today from, you know, ski holidays to, I don’t know, clothing and gadgets and yoga teachers and even dog walkers. Right?

Well, that’s the effect of the deflationary power of technology. And this process has played out against repeated doomsaying by very smart people, by the way. Wassily Leontief, (I probably butcher his name) Nobel prize winner, he said, in the ‘80s, that human labor was going to go the way of the horse, first diminished and then abolished (I’m butchering the quote a little bit). That’s what he said.

When automation really took hold, over the last 20 years, people said there was going to be mass unemployment in this current century. The story of the last 20 years was that automation is going to lead to mass unemployment. For the record, we’re almost near record low unemployment today.

So why is that? Essentially, it’s because of that deflationary nature of technology that frees up real incomes and people don’t save that. They go and spend it on other stuff.

[00:26:46] Kevin

I’ve got one more question about productivity and then we’ll move on. You’ve got a great graph. I have to say, I’m a kind of a bit of a geek with graphics and the graphics in the book are excellent. You’ve got one where you show the split, over time, of consumption between goods and services. It’s no surprise that, over time, service consumption goes up something like 60% of total spending now. And then next to it, you have your estimates of productivity growth across different sectors.

Goods sectors have actually had surprisingly strong productivity, and service sectors (and we’ve talked about this a lot on the show before), not so strong. And at the very bottom, you’ve got leisure, and you’ve also got health and education.

Those are the sectors one might imagine are going to expand in the future. And so, using your framework, is there going to be tightness in those particular sectors in the labor markets there? And then what labor-saving technology might be used to improve productivity? Is it realistic to expect productivity growth in those sectors? That seems to be the key to me.

[00: 28:03] Philipp

First off, the graph you refer to, we have it in there predominantly to calibrate this perception that there has been no productivity growth in the United States economy. It’s not really true.

It’s, in aggregate, it’s been disappointing, but under the hood, you have decent productivity growth in the physical economy. Why? Because you have technology that allowed for replacing labor at scale.

In services, you did not have the kind of technology that allowed you to do that. And because services are a growing share of the overall output, that mixed shift, where services gain an ever-bigger share, has dragged down aggregate productivity growth, even though you had pretty decent productivity growth in the physical economy.

So, I just want to make that point. This sort of conventional wisdom that productivity growth is doomed and low. It’s just not quite true.

To your question directly. So, this is one of the reasons healthcare, education, why, in a separate chapter in the book, we caution on the timeline and the size of these changes. We think this will have impact. AI will have impact. But a lot of the numbers that have been thrown around, I mean, they’re just not realistic and the timeline on which they’ve been thrown around.

I know, more recently, that has become more fashionable to argue, but keep in mind, after you finish a manuscript, it takes another year to hit the shelves for a long time. And we’ve published on this since 2020, when people were really, really enthusiastic about the zoom economy, and productivity was going to go through the roof and all that. Essentially, all these things are powerful, but the hurdles are high.

It’s not just, the ability to actually replace a lot of that human labor, but the acceptance by society. Who wants their child to be taught by an algorithm instead of a human teacher in a classroom? We all know how powerful teachers are in our own lives or have been in our own lives from kindergarten or pre-K all the way through getting a PhD, if you went that far. Of course, the teacher is a dominant figure in your educational journey. Who’s going to replace that, you know, tomorrow with an algorithm? We’ll find ways of complimenting that, perhaps in a smart way, but that’s not like flipping a switch. It’s going to take a lot of time.

Then in healthcare, it’s similarly promising, over the long run, slowly, but this is going to take time. I think we have some data points in healthcare.

The story of the AI radiologist is an old one, when radiologists were supposed to be replaced by algorithms that can read all these MRIs much more effectively and faster. For what I know is that the number of radiologists has grown in the United States since that technology has first landed. And it probably makes them better, or maybe the diagnosis becomes better, incrementally. But for what I know, and I’m not an expert there, I will have that disclaimer, I think the rollout and adoption and making this good has been much harder than envisaged. And the fact is that the headcount of radiologists has gone up, from what I know.

So, I think it’s sort of a reminder of how hard it is to do this, which doesn’t mean it won’t happen. It will happen. Just, we have to be realistic about the timing and the sizing of this. When I see these stories of GDP growth and that it’s going to go up more than a percentage point. No, it won’t, not next year, not the year after. Cumulatively, this will be powerful, but let’s just stay realistic is the message of the book.

[00:31:52] Kevin

Yeah, thanks for that. when I’ve talked to, say for instance, Mark Mills about this, and his view is that some of the stuff, the improvements in productivity and the healthcare sector, will be in the kind of less glamorous and have robots moving supplies and cleaning rooms and, maybe airlifting patients; the kind of physical labor that underpins a lot of what we see.

Let’s, if we could, pivot to two other risks, inflation and, and debt, in the next few minutes. So, you talk a lot about inflation, and you’ve got another good graphic that splits the world up into kind of four regimes: the four interest rate regimes, two are good and two are not so good.

The good regimes start with a base of what you call anchored inflation expectations. And I’m curious, you know, we’re in a world of tightness, as you say, and tightness means potentially upward pressure on prices. Why do you think inflation expectations are going to stay anchored in this world of tightness?

[00:33:07] Philipp

The case we’re making in the book is that we need to differentiate between cyclical and structural inflation. A lot of the commentary has gone off the rails over the last few years because commentators and in the press weren’t willing to differentiate between the two.

Structural inflation has a lot to do with inflation expectations. What are the long run expectations of inflation? And if you look carefully, over the last few years, as we went through this cyclical inflation crisis, inflation expectations stayed firmly anchored.

So, whether you looked at market-based indicators, like five year/five year break evens that you can back out of traded securities, or whether you looked at survey responses on what do consumers expect inflation to be five years down the road. Even at the height of inflation, there was little evidence, actually no evidence, that we’re sort of moving back to the 1970s style with unanchored inflation expectations, off to the races price wage spirals, and all that stuff that dominated headlines, and frankly, it was not a productive line of argument in ‘22, ‘23, et cetera.

Now, what we’re saying also is that because of this era of tightness that we believe in, we think inflation is likely to be upward biased cyclically. So, monetary policy will more often have to tamp things down.

In the 2010s, you struggle to reach the 2% target. And in the 2020s, it’s quite plausible that more often you’re going to be somewhat above it, and you’re going to have to sort of bring it down towards what you believe as a good level; whether that’s 2%. Whether we start rating that a little higher is a whole different conversation.

So cyclically, we think the bias is up, but again, that’s a very different question from the one about structural inflation, which is determined by inflation expectations. Are they anchored or are they unanchored?

We’ve not seen an unanchoring of inflation expectations. I think that would take a big crisis, a big failure of policy. So, policy has done its job. You can criticize the Fed all you want, but they did not let this go to a disaster zone where you had to protect the inflation regime. They did act, they did stand up and they did act.

They did attempt a soft landing, and they were proven, right. I mean, this is a success. This is not over clearly that far into the process it’s kind of funny that we’re still debating. Are we, are we getting a soft landing? I mean, clearly inflation’s down so much, and the labor markets held up so well, II think these guys deserve a little more credit than they’re getting in the routine bashing left and right.

So, essentially inflation expectations have every reason to remain anchored. And cyclically, you’re going to see that inflation buys upward and that will require more intervention from monetary policymakers, but that remains a healthy environment where we call interest rates ‘higher but healthy’.

It’s a change in perspective from the 2010s where rates were artificially low. Long rates were essentially controlled at a low level through QE. This is likely going to be a very different environment, but just because rates are higher and edging up, it doesn’t mean it’s a bad world. If rates are higher because of tightness, that’s actually a good reason to have higher rates. Not a bad reason.

[00:36:39] Kevin

Yeah. I’ve been talking and I’m curious if you think this is a valid framework or not, but I’ve been talking about thinking about long-term interest rates going forward as well.

You know, if inflation target is 2%, but we end up with kind of somewhere like 3% to 4%, and the Fed keeps a positive real rate of like half a percent or something. And then you have a upward sloping yield curve. It’s not hard to imagine long-term interest rates being kind of in the 5% to 7% range. That seems to me consistent with a world of higher inflation and an upward sloping yield curve.

[00:37:18] Philipp

That strikes me as a little high – 5% to 7%.

[00:37:22] Kevin

So, 5% to 7% for long-term US government bonds strikes you as high?

[00:37:27] Philipp

Yeah, like a 10-year duration, 5% to 7% on a regular basis. I find that quite high.

[00: 37:35] Kevin

Okay. So, that’s fine. So you’re thinking, if you think sort of inflation is, let’s say, 3% instead of 2%, then you’re expecting a pretty flat yield curve going forward.

[00:37:53] Philipp

Well, there is some steepness always outside of cyclical distortions that we have, where we’re fighting acute bouts of inflation, there’ll be some steepness in the yield curve. But the question is where is R-star? Where’s the neutral rate of interest? Nobody knows for sure where it is. You can look at what the Fed believes that it is around 3%.

So, there’s a lot of uncertainty around what is actually tight monetary policy on a cyclical level? Are we very tight right now, or are we just marginally tight?

It all depends on where is R-star, the neutral rate of interest. And so, what I think I’m willing to believe is that R-star is lower today than it was in the 1990s. In the 1990s, in all likelihood, the neutral rate of interest was significantly higher.

The 1990s was also kind of tight. At least the second half of the 1990s was this kind of era of tightness. We talk about a pressure cooker economy, lots of investment, labor was scarce.

What kind of interest rates did we have back then? You know, 6% to 7%, but yet had a much higher neutral rate of interest. Now, when you think that R-star, or the neutral rate of interest, has come down over the last 20, 30 years, what kind of equivalent interest rates might be consistent with a tight and pressure cooker economy?

If it took 6% to 7% in the late nineties, or in the nineties across the board, with a higher R-star then in the future, with a lower R-star, I don’t think it takes that high an interest rate level to have an equivalently responding interest rate to that tightness, that level of tightness.

[00:39:39] Kevin

Okay. I have one more question sort of about policy and inflation. You say, in the book, and it’s pretty much that most people recognize this. We’ve been in a world, in the 30 years, where there’s been a downward bias to inflation, where the shocks that have hit the world economy had been deflationary shocks.

In that world, where the kind of underlying key macroeconomic risk is deflation, if you respond to a financial crisis (you have a financial crisis in 2008, 2020), you respond to it with stimulus to help the financial markets. You’re also going against the prevailing macroeconomic risk.

In other words, providing liquidity to help them help markets is inflationary. But if the main economic risk is deflation, then you’re kind of killing two birds with one stone. And if we’re now in a world where there’s an upward bias to inflation, then does that make the effectiveness of crisis intervention… Does that reduce the effectiveness? Because now you’re providing liquidity in a world that’s tight, as you say, where there’s an upward bias to inflation. Does that constrain the ability to fight financial crises?

[00: 40:59] Philipp

Yeah, it’s, it’s a great topic. The suggestion we make in the book is that we really need to differentiate between what we call existential stimulus on one hand, and tactical stimulus on the other. Existential stimulus is the ability of policymakers to backstop the system in moments of true peril, like 2008, like 2020. And the ability and the willingness has been powerful. I mean, it was on display in sort of big fashion. And we think that ability is not going away.

Financial markets will finance that stimulus if the next big systemic shock happens, particularly in an economy like the US but even other advanced economies, we think so. That is very different from tactical stimulus, which is more of a frivolous, culture of stimulus that has grown over the last few decades, many decades. We actually traced this back to Reagan.

Even though Ronald Reagan and the Republicans have claimed the mantle of fiscal responsibility, juicing the economy and the cycle through spending and debts is certainly something that first occurred in the eighties. And debt was pushed much higher in the eighties. And then we’ve added to those fiscal tools of stimulus. We’ve added monetary tools.

So, that the Fed put is sort of the classic reaction to tactical cyclical weakness. You had that in 2018 going into 2019. You’ll remember sort of interest rates were going up. The Fed was hiking a little and then markets sold off. And then the Fed made a U-turn and got the policy right.

That was sort of the classic Fed put. That was very easy and costless in a world where you struggle to even get 2% inflation. I mean, that was the context of the pre COVID era where you didn’t get to 2% inflation on a regular basis. Most of the time you were somewhat below.

Now, in a world where inflation is uptwardly biased, this tactical stimulus, the frivolous kind, is going to be more constrained. And that does not impact the existential kind, we argue. If you get into another really difficult situation where the system is at risk, you’ll be able to act. And we think politically you will be willing to act. It’s both about ability and willingness. And I think that on the existential side, you check both boxes.

[00:43:27] Kevin

I think it boils down to, in my interpretation of what you’re saying, is that existential crises, they’re always deflationary. And therefore, we’re going to be able to have the tools to handle a deflationary crisis that existential tools are not about. In your world where, I guess, you can make counterexamples of Germany, whatever, in the 1920s, but it sounds like what you’re saying is that you don’t anticipate those type of existential crises.

[00:43:59] Philipp

So, the risk of such big crises is a deflationary depression. In 2008, that was a credible risk. In 2020, if you hadn’t acted and just let this play out the way it happened in the 1930s, the great depression was essentially policy made. Policymakers stood by and watched the economy bleed out. They didn’t intervene monetary wise. They didn’t intervene fiscal wise for a while. The Great Deal tried to correct for that, sorry, The New Deal tried to correct for that later.

Essentially, the risk of such crises is a deflationary down draft, and that’s why you should, and we argue you can, act big to prevent that and backstop that sort of deflationary draft. And you did so successfully in 2008, you did so successfully in 2020. Keep in mind in 2008, it was still a little more controversial.

TARP? TARP was a $700 billion package, which was initially voted down in Congress. And when it was voted down, the stock market sold off real hard in the space of, I forget, 15 minutes.

[00:45:01] Kevin

I remember that day very, very well. I was running a very large levered fund. So those were, yeah. I remember specifically that day, and yeah, that seems like a drop in the bucket now, given all the tools that have been deployed at various times.

[00: 5:18] Philipp

I think it is a powerful reminder though, that the willingness to act, the political willingness to act ultimately is there. Despite all of the partisan posturing, neither side wants to see the house burn down just because you can’t politically align.

So, I think, in the moment of existential crisis, you see bipartisan policymaking return as you did see in 2020. And I think that’s a plausible argument for the future.

But back to the tactical stimulus, it’s totally different story, tactical stimulus. That is the kind of story of, of Liz Truss in the UK. Oh, you want to juice the cycle, kind of frivolous. You want to throw more money at the economy. And now because inflation is upwardly biased, the market says no. And the market comes and vetoes this, bond markets veto this (sometimes referred to as the bond vigilante), and is kind of a step up and say, no.

Can that happen in the US, it could. I think it’s a much higher bar in the US given reserve currency status, a different treasury market, et cetera. But it certainly is a bigger risk, now in the US, when inflation is upwardly biased. And don’t forget, history has had such episodes in the US too.

So, we, we quote in the book, Jimmy Carter, whose 1980 budget was essentially punished by bond markets. When he restated the budget, you know, much bigger figures, the 10-year sold off real hard, rates spiked, and that is seen as having contributed, also, to his election loss.

[00:46:46] Kevin

Thanks for that. That’s an important distinction between existential and tactical crises and our ability to navigate those. One thing that a lot of people worry about, we’ve talked about it on the show, is debt.

You talk about that. You have a couple of chapters, and you are very clear that it’s really not the debt levels that matter so much as the rate of growth in the economy relative to the interest rate. So, when people say, “Hey, US debt’s a 100% of GDP and we’re in for a crisis,” your view is, hey, let’s step back and think more carefully about that. So, what’s your framework for thinking about the extent to which the level of government debt is a problem for us?

[00:47:39] Philipp

Right, you know, this takes us back where we started earlier about master model thinking and reducing economics to sort of a physical science kind of framework. I mean, keep in mind that very smart people have tried to put a framework around this.

So, Reinhart and Rogoff, they came out with thresholds of debt to GDP ratios that they said would lead to calamity or at least sort of very sharp slowdown in growth. These thresholds have not held. Essentially the entire framing of debts, in terms of levels, is dangerous and tricky.

Why? If you tell me how many trillion dollars of debt in a country, or the debt to GDP ratio, these are both nominal measures of debt. These are both measures of the level of debt. It says very little about their debt sustainability.

So sovereign debt crises happen at very low levels of debt, and they don’t happen at very high levels of debt. I think about Japan, nothing there. And you’ve had economies at much lower levels of debt, like below 70% and 60% with a sovereign debt default.

So just right off the bat, empirically your debt to GDP ratio is a poor predictor, I think, of true risks. What we want to look at is the sustainability to carry whatever load of debt, whether it’s very high or more modest.

The question is, is it easy or hard to carry back on a debt level? And that comes down to two variables, the nominal rate of interest compared to the nominal rate of growth. And if my nominal rate of growth is higher than my nominal rate of interest, I can carry a very high level of debt.

In fact, if the spread is favorable, my nominal growth is higher than my nominal interest rate, I finance those out of current growth. And, actually, my debt to GDP ratio will fall.

So, we compare that in the book to walking on one of those, you know, airport moving sidewalks where you have sort of a nice kind of a tailwind to yourself. But if rates rise above the nominal interest rate, you’re thrown onto a treadmill. Now you have to exert effort, spend money, real resources, just to keep the debt to GDP ratio, constant, which can happen.

It’s not automatically game over then it just gets painful and, and it’s a very different game. So, we look at a hundred years of R versus G in the United States. Mostly we’ve lived in a favorable R versus G environment.

[00:50:16] Kevin

Rr being the interest rate and G being the growth rate.

[00:50:20] Philipp

Sorry, yes, absolutely. So, I forget.

So yeah, nominal interest rate R versus nominal growth rate G. Mostly we’ve lived in a world where G was faster than R and that actually made these debt levels rather sustainable. The 2010s were extreme in that regard because financial repression, QE, low rates, they compressed rates so much that clearly they were far lower. Interest rates were far lower than the growth rate, even though the growth rate was also kind of meek interest rates were even lower. So, it was very favorable.

So, we think that that favorability is shrinking, but we don’t think you necessarily will see rates rising above nominal growth. And even if you do, or if they’re roughly the same level, again, that’s not like you’re falling off a cliff. You’re just going to have to make more painful decisions.

It’s sort of the whole cliff edge culture of looking at this, you know, another billion dollars in debt and that breaks the camel’s back. This is the kind of master model framing of sovereign debt that just really doesn’t help in our view. And the book makes that case.

[00:51:31] Kevin

So, it really loops back to things like productivity and what’s realistic in terms of influencing that rate of growth. When you say higher, but healthier rates of interest, it can’t be too high, right? It is high because it reflects, you know, kind of tightness and more growth opportunities, more investment, but not so high that that starts squeezing the ability to pay back debt.

Well, so I want to wrap up and we’ve talked a lot about risks, and your book is about evaluating risks and a framework for thinking about them. But I don’t want to leave people with the impression that this is a pessimistic book, it is not.

You say that we’ve been living in a world of good macro, and going forward it won’t be the same good macro, but still generally speaking, the environment ought to be favorable. Would you mind just kind of like summarizing for us the broad macroeconomic conditions you expect to prevail going forward and why you think it’s still an attractive one for the economy in general.

[00:52:50] Philipp

Yeah, ‘good macro’ is a term we use to describe the operating system, if you will, of the economy and it splits into three parts. And, by the way, the book splits into the same three parts. We can evaluate risks in the real economy, and the financial economy, and in sort of the global geopolitical dimension of the business environment. And the book is split exactly that way. And each part has, five, six, seven chapters to look at individual risks within those three buckets.

Good macro refers to the fact that the real economy, the financial economy, and the global economy over the last three, four decades was decidedly favorable for business and executives and investors.

In the real economy, you had lengthening business cycles, less volatility. You have had fewer recessions, so there was an ability to grow things and to build businesses. In the financial economy you had a long path down in terms of inflation, since the eighties, that pulled out interest rates, that was very, very helpful to valuations. So, from an investor perspective, this was sort of a structural upshift.

In the global economy, you saw, the proliferation of value chains and essentially rules and institutions that brought global business and into a synced operating system. Because of that, a lot of executives, they’ve grown up with that as their context, this is their frame of mind. It’s almost like the mindset of good macro. You didn’t really have to think too hard about global macro because it worked in your favor. It kind of operated in the background.

It wasn’t sort of day-in-day-out stuff in the boardroom and the C-suite, because it kind of just worked in one direction. Beautiful, you know, didn’t have to be all too aware of it. And that has changed. Global macro is now front and center for many executives who didn’t usually think about it explicitly.

I spend a lot of time in boardrooms and executive settings where pre COVID that was more on the investor side. So, everyone kind of has to grapple with it. What the book says is that good macro is changing.

So, some of these things are not as favorable. There’s more volatility. But we still think that, at heart, these elements of good macro are still quite powerful, and they will be preserved in many shapes and forms. It’s not as clean and as convincing as it was in the last preceding 15, 20 years, where, by the way, you also had hiccups and, you know, moments of crises, including 2008. But overall, you had the sort of plane sailing, everything moved in one direction.

Going forward, we still think this holds true in the real economy, back to the era of tightness. We’re essentially seeing more tightness in the labor market, driving better growth by the elements of productivity growth that we discussed earlier. We think that has a knock-on effect in the financial world. Those higher, but healthy rates, keep in mind, this will drive better capital allocation.

Capital was too cheap in the past, leading to capital allocation that could be questioned and should be questioned often. This will likely lead to better capital allocation as long as rates are high for reasons of a strong economy and not because of higher inflation expectations.

This is a good, higher but healthy rates, we call it. And in the global realm, we’re quite adamant that the risk is least predictable there. And this is where a lot of forecasting often goes very, very wrong.

It seems like a downgrade in the global realm too, but in the end, global trade has held up rather well. And we think that, while it’s stopped growing aggressively, we show, for example, when you strip out commodities trade, trade as a percent of world GDP has actually proven really resilient.

So, I think, taken together between the real financial and global dimensions, global macro demands more vigilance, demands a lot more engagement by executives and investors. But we, we really don’t think that it’s warranted to go all negative doom and gloom. There are lots of good things that are still working well for those operating in the global economy.

[00:57:20] Kevin

Well, I appreciate that. And thanks for the summary. And thanks so much for joining us today.

[00:57:26] Philipp

Thank you for having me. Thank you so much.

[00:57:29] Kevin

All right. This has been, it’s been a great conversation. Shocks, Crises, And False Alarms, we just scratched the surface of it. There’s a lot in there, including some great graphics, but also really understandable frameworks for thinking about the global economy. So please make sure you follow his work. You can tell from what we’ve been talking about that a lot of these ideas and topics are not being discussed enough on mainstream media.

So, for all of us here at Top Traders Unplugged, thanks for listening. And we look forward to continuing the conversation.

[00:58:03] Ending

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