March 26, 2023
by Stephen Stofka
This week I’ll look at things that are hard to measure and their effect on our lives. Much of human activity is recursive, meaning that the outcome of one action becomes the input to the next iteration of that same action. When we get nervous we may breathe fast and shallow which changes our body chemistry increasing our anxiety and we continue breathing fast and shallow, amplifying the effect. Because of that cyclic process prominent thinkers like Aristotle, Adam Smith, David Ricardo, Karl Marx, and Joseph Schumpeter, among others, have proposed circular models of human behavior.
The 19th century economist David Ricardo modeled the industrial process as a profit cycle. Increasing or decreasing profits mark the division between two phases of the cycle. The first phase is a series of more and higher –
leading to more output,
an increased demand for labor,
a rise in wages,
a rise in population and consumption,
an increasing use of less efficient inputs,
then higher interest rates,
and lower profits.
The decline in profits signals the end of the expansion and begins the downward phase, a cycle of less and lower of each of those elements – less investment, output, less demand for labor, lower wages in aggregate, etc. Ricardo assumed that workers received subsistence wages so an individual worker might not work for wages any lower. Like his friend Thomas Malthus, Ricardo assumed that higher incomes would lead to an increase in population. In the early 19th century, less efficient inputs meant less fertile land. As our economy has transitioned to become almost entirely service oriented, the less efficient inputs are labor. It is difficult for a hairdresser or therapist to become more productive.
Since the pandemic companies have been rewarded for raising prices, a strategy Samuel Rines, managing director of the research advisory firm Corbu, called “price over volume” on a March 9th Odd Lots podcast. With this strategy, companies like Wal-Mart keep pushing prices higher, willing to accept lower volume as long as total revenue and profits are higher. After-tax corporate profits (CP) have risen more than 40% from pre-pandemic levels, according to the Federal Reserve.
In Ricardo’s model of the profit cycle, higher prices lead to higher interest rates as investors increase their demand for money to take advantage of the higher prices. In our economy, the Fed controls the Federal Funds interest rate that other rates are based on. As prices continued to rise, the Fed began to lift rates and has raised them more than 4% in the past year. As the Fed raises rates, bank loan officers tighten lending standards, beginning with small firms (DRTSCIS) and credit card loans (DRTSCLCC). The FRED data series identifiers are in parentheses. In the past year, banks have increased their lending standards by more than 50% for small firms and 43% for credit card loans. However, all commercial loans have increased by 15% in the past year and delinquency rates have not changed since the Fed started raising rates. This is part of Ricardo’s model. Investment does not decrease until profits decline. Profits (CP) still grew at 2.25% in the 3rd quarter of 2022. We are not there yet.
In the 4th quarter of 2022, real GDP grew at less than 1% on an annual basis. We won’t have an estimate of 1st quarter numbers until the 3rd week of April but employment remains strong. Since 1980, the population adjusted percent change in employment goes negative or approaches zero just before recessions. In the chart below, notice how closely the employment (blue line) and output series move in tandem. The red line is the annual percent change in real GDP.
We may be approaching the pause point but the point of decline could be six months to a year away. Although the Fed let up on the “gas pedal,” raising rates by ¼% rather than ½%, they showed their commitment to curbing inflation as long as the employment market stays strong. If the Fed had not raised rates this past week, they would have set expectations that they were done raising rates. For now we can look for these signs that the expansion of the business cycle in Ricardo’s model is coming to a close.
Photo by Lukas Tennie on Unsplash