Epic or ‘great’ recessions are caused by the overlapping or congruence of financial-banking crashes and the deep contraction of the non-financial real economy. A contraction in the financial economy can precipitate and exacerbate a contraction in the real economy. And vice-versa. By ‘real’ is meant GDP–that is, investment in buildings, equipment, inventories, etc., and household consumption. By ‘financial’ is meant financial assets like stocks, bonds, derivatives, options, futures, etc.
In a ‘normal’ recession, forces cause the ‘real’ economy to contract–i.e. GDP to go negative. Such real contractions are typically short lived, however, typically less than a year. And there is no corresponding financial asset price crash, credit crunch, defaults or bank failures.
In contrast, in an ‘epic’ or ‘great’ recession, either a financial crash precipitates and drives a real economy lower than ‘normal’ for a recession; or a real recession leads to an eventual financial crash and a deeper recession. In both cases, the dual contraction results in both the financial and real side of the economy exacerbating each other. The contraction thus goes deeper, and therefore lasts longer–typically in a great recession 12 to 24 months; sometimes longer, with short shallow recoveries followed by short, brief re-recessions. The latter describes Europe after 2009, with a double dip recession 2011-13 and weak recoveries followed by stagnant barely 1-2% growth. It reflects even more the case of Japan after 2009, which experienced three recessions over the next ten years and very weak recoveries between.
To understand the dynamics between financial cycles and real business cycles, it is necessary to understand the relationship and causal interactions between financial asset investing in stocks, bonds, etc., on the one hand, and real asset investment in buildings, structures, plant, equipment, inventories, etc. In both cases of financial and real investing, the growth of excess debt is a ‘marker’ of the growing potential for instability (contraction). Debt grows in late capitalism at double the normal rate. Credit is extended, creating a debt, for the expansion of real investment; but it also grows, increasingly and ever-more rapidly in the 21st century, to fuel financial asset investment. Understanding how debt makes both forms of investment ‘unstable’–or to use an alternate term ‘fragile’ and prone to crisis–is central to understanding how and why financial cycles and real business cycles overlap and exacerbate each other, in the process creating more severe downturns called ‘great recessions’.
But debt levels by themselves are not the cause of crises. What matters is the ability or inability to ‘service’ that debt–i.e. pay its principal and interest when due. So long as prices for financial assets continue to rise, and prices for real goods and services continue to rise as well, debt levels may rise in turn without creating a crisis. However, when prices deflate, and revenues and cash flow with which to ‘service’ the principal and interest on debt collapse in turn, then debt levels matter. In other words, it is the relation between debt and price deflation, and revenues/cash that is central to fragility. A third element is critical as well. Defaults, which mean failure to pay interest or principal on the debt coming due. Defaults lead to further declines in price (deflation), revenues, and available cash with which to service the debt. A downward spiral of both financial asset and real asset investment follows, the one exacerbating the other in a mutual negative feedback effect.
The following Part 2 excerpt from my 2010 book, ‘Epic Recession: Prelude to Global Recession’, described these basic relationships between financial asset and real asset investing, debt accumulation, deflation, and defaults in the run-up to the 2008-09 dual financial-real economy crash. It is the causal interaction of these variables that drive the deep, dual contraction called great recessions. In 2008-09 it was the financial contraction that precipitated and drove the real contraction; today, 2020, it appears more likely this will be reversed, with the real side driving the collapse of the financial side.
Real Investment As Basis for Financial Investing
Financial investment begins on a base of real asset investment. For example, a property, i.e. a real asset, must be built before a mortgage, or financial asset based upon that real asset, is in turn issued. Thereafter, additional financial assets may be issued based upon the initial financial asset. These are called derivatives. A mortgage forms the basis for the issuance of a mortgage bond composed of various individual mortgages or parts of mortgages. The growth in real assets thus initially provides the basis for subsequent expansion and growth of financial assets. But the process of financial asset creation soon diverges from its real asset base. And the more they diverge, the more asset price inflation is driven by forces independent of original real asset investment. And as asset inflation becomes more independent it also becomes more volatile.
Concerning the real investment side: in the early phase of a business cycle, opportunities for profitability from real asset investment are greater than in late stages of the cycle. Prices for materials and intermediate goods, and therefore costs, are relatively low. There are few pressures in labor markets to raise wages. Costs are therefore minimal and possibilities for rapid gains in productivity higher. All things equal, lower costs mean higher expected profits and therefore plans for increasing real asset investment. Expectations that prices will increase as the business cycle develops means additional expected profits and plans for investment. Product development preparation during the recession, in anticipation of recovery, provides an additional potential boost to investment. In short, expectations of profitability are higher than average in the beginning of a boom phase and therefore plans for, and actual, investment higher than average. But over the course of the business cycle, the above positive elements weaken, profitability ebbs, and with it plans for, and actual levels of, real asset investment. But that does not necessarily inhibited financial asset price inflation from accelerating.
As investment in real assets initially rises, the foundation for financial speculation also rises. In the beginning, speculative investing is based on prior real asset investing. For example, residential and commercial property real assets must be created first, before subsequent speculation on those assets is possible. Similarly, a supply of commodities—whether food, oil, metals, or in other forms—must be created before speculation on those commodities can occur. Issuing new stock with which to finance real investment results in stock price volatility, upon which speculators may then enter the market. Similarly for bonds created from bundling of mortgages. Whereas the initial mortgage represents a first tier financial instrument, the stock price appreciation and bond yields represent second tier financial instruments.
To summarize, real asset investment initially provides a basis for speculative financial asset investment. As the latter accelerates, it creates a new for additional real assets on which to create further financial assets. It may thus artificially stimulate real asset investment to a degree. But as will be described shortly, increasingly over the boom cycle speculative asset investing becomes based less on real asset investment but more on previously created financial assets. As a consequence of this shift, disproportionality grows between real asset investment and speculative asset investment.
Financial Asset Speculation As Driver of Excess Financial Investing
The preceding described how the real asset provides the basis for a speculative financial asset. The house creates a first tier ‘mortgage’ and mortgages of various homeowners are bundled to create a ‘mortgage bond’ (RMBS), a second tier financial instrument. But there are further ‘tiers’.
A third and even fourth tier occurs when yet another layer of financial instrument is created on the preceding layers. Stimulating the demand for third and fourth tier financial assets are the availability of extreme ‘leveraging’, as well as the spread of securitization and widespread availability of secondary markets in which to sell the third and fourth tier of financial products.
In the third tier, previously created second tier financial instruments are repackaged, then mixed with other short term financial issues like asset backed commercial paper, or ABS. The new repacked financial issue is marked up in terms of price, and then resold once again in other secondary markets. These resales are often global, since the product itself has no distribution costs and is available electronically. These financial ‘products’ also have virtually no production costs. Supply is not a factor and plays little or no role in pricing of these products. Price movement of third tier instruments are even more independent of the original real asset. They become virtually demand driven, and thus quite unlike prices for real asset products, where tightening supply and slowing demand over the course of a business cycle eventually constrain further price increases. Financial asset prices, in contrast, have no supply constraints and are driven by ever greater demand almost exclusively.
As prices for second and third tier financial assets begin to diverge from real asset prices, supply and demand forces begin to slow real asset price increases as expectations of profitability weaken and decline. Declining expectations for profitability leads to slowing real asset investment. Real asset investment slows, just as financial asset investment begins to accelerate. More liquidity and credit subsequently flows into speculative investing and out of real asset investing. In other words, an imbalance and disproportionality begins to emerge between real asset investment and more speculative forms of financial asset investing, as well as between their respective price systems.
In this situation, creators of financial instruments are confronted with a dilemma: either get more physical asset investment into the pipeline or create more speculative financial instruments from other financial instruments. This is what precisely occurred during the subprime mortgage boom in the U.S. Banks and other financial intermediaries in the U.S. needed a continued flow of mortgages loans in order to create their residential and commercial property mortgage-based bonds, RMBS and CMBS financial instruments, to securitize and resell into secondary markets. So they sent people into the field to instruct mortgage lenders how to develop a greater volume of mortgages and loans. This was called ‘originate and distribute’. Quantity of mortgages was all that mattered, not quality.
First and second tier financial assets are mortgages, bonds, stocks, etc., whereas third tier financial assets are even more highly leveraged, further securitized, and resold in global secondary markets. These include typically collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), asset backed commercial paper (ABCPs) and other asset backed securities (ABS)
There is a fourth tier of financial instruments as well, however. That is the creation of credit default swaps (CDS) and other insurance instruments as cover for the increasingly risky character of second and third tier instruments’ quality and quantity. But CDSs quickly become more than mere insurance. There are, in effect, essentially ‘bets’ on the likely degree of failure of the prior tiered instruments. As profitability from financial speculation rises with financial asset inflation, it in turn fuels even more speculation in various ‘higher level’ derivatives like CDSs. Other fourth tier instruments include interest rate swaps, currency swaps, and other over the counter derivatives. These are all forms of ‘casino investing’, or investment as pure ‘betting’.
To partly sum up, real asset investment initially enables speculative asset investment. But as the general business cycle develops, the much greater price-driven profitability of financial speculation begins to feed upon itself. Financial speculation creates more financial speculation, thus increasingly diverting capital from real investment just at a time when growing supply constraints begin to raise costs of real asset investment, lower its expected profitability, and in turn consequently slow real asset investment. The falling real returns, actual and expected, from real investment diverts liquidity and credit even more to speculative investing, which drives the demand and price of the latter still further. Speculative asset prices begin to accelerate while real asset prices slow. The former becomes relatively and increasingly profitable and the latter less so. .
As professional investors and their ‘shadow’ institutions grow in number, weight and the liquidity they control, the overall effect is an increase in demand for speculative assets and a slowdown of the demand for real asset investment over time. Speculative forms of investing therefore have over the longer run a relative net negative impact on non-speculative asset investment. It is not that speculative investment ‘crowds out’ real investment, but that it diverts and distorts it. It over-stimulates some forms of real investment, while it slows other forms of real investment while the net effect is negative. Major disproportions and imbalances are the consequence—which become major contributing forces to financial instability.
Financial Investing and Acceleration of Excess Debt Accumulation
There are at least two ways in which speculative investing accelerates the accumulation of debt. It does this first by transforming debt simple leveraging into a kind of super ‘layered-leveraging’. By layered-leveraging is meant securitized leveraging. As previously noted, speculative investing by definition relies heavily on leveraging per se, just as it does on opportunities that are short term and price driven. However, securitization significantly increases leveraging even further (and thus levels of debt) by enabling multiple ‘tiers’ of leveraging. That is, at each tier of financial investment, the purchase of each repackaged financial asset is leveraged. Leveraging thus occurs multiple times. For example, mortgage bonds are rolled into collateralized debt obligation (CDO) securities. Those CDOs are repacked into and resold as part of a ‘synthetic’ CDO—a CDO created out of bundling other CDOs. Credit default swaps are created to ‘insure’ against the risk of the preceding. Along this chain of ‘financial instruments created out of financial instruments’, additional leveraging and borrowing—and thus debt creation—takes place at each level. In short, securitization multiplies the volume of debt by enabling levels or ‘tiers’ of leveraging. We have debt and leveraging based upon previous leveraging and debt.
Securitization additionally promotes greater investor risk taking, all things equal. With the possibility of quickly selling the asset after a short term on a secondary market, the investor develops a false sense of reduced risk that encourages further speculation and leveraging. If there’s a secondary market, investors believe they can quickly dump the asset by reselling it should its price stop rising or begin to fall. The very existence of secondary markets for securitized assets therefore encourages excess risk taking. As Keynes put it, they believe they can determine what the average investor will do better than the average investor can and that they can ‘get out’ before the market slows or collapses.
In short, securitization and secondary markets serve to increase the trend toward speculative investing by appearing to reduce risk and by enabling layered-leveraging. The greater leveraging and false sense of reduced risk translate into a greater volume (and reduced quality) of debt than otherwise would occur. The problem is that secondary markets for securitized assets work as an exit only when asset prices are rising. As soon as asset prices begin to fall rapidly, there is no secondary market in which to exit from. Everyone is trying to sell and no one is buying—and by definition there is no market when no one buys and everyone tries to sell.
(In Part 3 to follow: The Debt-Deflation-Default Nexus & Great Recessions)
Dr. Jack Rasmus @drjackrasmus
Jack Rasmus 
[…] It is only the latter that is more likely to lead to a Great Recessions – or worse. Read Jack Rasmus […]