Economic Warnings You Need To Hear

The US economy has taxied down the runway since the end of the recession in 2009, with a failed attempt to take off each year. Now we try again. The throttles are firewalled, the crew and passengers excited at the prospect of takeoff . But some begin to worry as the end of the tarmac appears ahead. On the FM website you’ve read some of these concerns.

Here are two reports looking at our situation from different perspectives, both confident but cautious.

(1) Weekly report by Michael Hartnett, Chief Strategist, Bank of America Merrill Lynch, 12 September 2013 — Red emphasis added. As clear an analysis as I have even seen.

An unprecedented financial and economic crisis, crystallized by the September 15th 2008 bankruptcy of Lehman Brothers, was followed by an unprecedented monetary policy response, which in turn has been followed by unprecedented bull markets in bonds, stocks, and now real estate. Wall Street has soared, but Main Street has soured. The exceptional “sweet spot” engendered by generous central banks and selfish corporations has been great for owners of capital, but bad for labor.

Significant monetary stimulus, the end of fiscal austerity, a booming housing market, a cheap dollar, record corporate cash balances — if the US economy does not significantly accelerate in the coming quarters, it never will. We assume it will…”

On the other hand, The monetary stimulus of QE3 might have little effect. Rising interest rates might slow or cripple the home construction boom. Corporate cash only stimulates if companies accelerate their rate of investment in the real economy (which does not yet appear to be happening). The unstated, even unspeakable, alternative is that the US has followed Japan in a long intractable cycle of slow growth. The next few months will show the true picture.

(2) For a larger scale perspective see this excerpt from the long, brilliant, and disturbing “A Nominal Problem” by Jim Reid, Nick Burns, and Seb Barke; strategists at Deutsche Bank;, 12 September 2013:

The Debt Supercycle (unmentioned and unmentionable)

This report argues that nominal GDP is important as we live in a nominal world. We receive wages, pay our debts and manage our savings in nominal terms. In the current environment, we continue to believe that nominal GDP is more crucial than normal as we have record and climbing levels of global debt which is virtually all nominal. … In this piece we construct a comprehensive nominal global GDP series (split by regions) back to the late 1920s and find that the 5-year moving average global nominal growth rate is now at its lowest level since the 1930s. This has been driven by the developed world. But even in {the emerging nations} growth in many countries/regions is flirting with the lower end of the most recent decade range. …

Why has growth been so weak in this recovery?

This question has vexed the greatest minds in economics and the financial industry but one would have to say that too much debt has been a hindrance to many whereas trying to reduce it too quickly (austerity) has been an issue for others. The problem may actually be that growth was too high in the leverage bubble of the decade that preceded the financial crisis. As such we are flat-lining until we ‘catch-down’ with the appropriate new trend rate of growth. Perhaps this trend rate of growth has been declining due to demographics and this is now slowly being exposed post crisis. This is more true of the developed world but even in {the emerging nations} many countries are either past or are fast approaching their demographic peak

We think nominal GDP is crucial in this cycle as the debt burden remains incredibly high relative to history. The sooner we can start to meaningfully erode it, the sooner we can reduce its inherent systemic risks and potentially free up animal spirits.

Conclusions
Propping up bubble-era debt with ultra low interest rates and QE has arguably locked in an inefficient allocation of resources throughout the developed world. {The emerging nations} have also been increasingly guilty of such activity post 2008. In an ideal world we would have liked to see more cleansing of debt over the last five years which would have helped eventually free up animal spirits, encouraged a more efficient resource allocation and allowed for more new entrepreneurial activity to prosper.

However this would have likely had a dramatically negative short-term impact on the economy and possibly on social cohesion. Politicians needing to be elected would also have been unlikely to sign off on such policy. As such we have to be realistic enough to assume that this path is now unlikely to materialize.

The authorities therefore have two options if growth continues to be so moribund. They can either continue with the just-in-time management of the problem that has existed since 2008 or they can start to be more radical and consider options that look a lot more like helicopter money. Given the worsening demographic outlook and the still systemically high debt levels such a bold approach might eventually be needed.

We’ve previously been of the opinion that the end game to the 2008- financial crisis is notably higher inflation at some point in the second half of this decade. While we continue to expect such an outcome, it has always been predicated on liberal money printing by central banks over the coming years. If Fed tapering marks the beginning of the end to this policy globally then it’s unlikely that inflation will be a big issue in the years ahead. However we think that the reduction of global central bank liquidity in a high debt, poor demographic, lower real growth world will eventually expose the globe’s economic problems again which will inevitably lead to more monetary activism. So we don’t see the expected imminent US tapering as the end of unorthodox monetary policy.

I’ll take the other side of Jim Reid’s bet on inflation.