I can very well imagine catastrophic or merely unpleasant scenarios for the coming decade. In fact, they are the most likely outcome of the situation we find ourselves in. However, all this talk about doom and gloom got me wondering whether we might be overlooking positive outcomes. After all, it was not so long ago in 1979 that we were announcing the end of Western civilization. The West had suffered from two oil shocks. Stagflation was rampant with both inflation and unemployment above 10%. The US had lost Vietnam and most of South East Asia was under Soviet influence. Latin America was mostly governed by dictatorships. China was still extraordinarily poor after the follies of the Great Leap Forward and the Cultural Revolution. Theocracy had been instituted in Iran. The future looked bleak for the West.
No one predicted the golden age we were about to enter, that the course of the next 30 years would profoundly alter the face of humanity for the better. We witnessed a technology-led productivity revolution. Inflation and unemployment both sustainably fell. Dictatorships were replaced by democracies across Eastern Europe and Latin America. The integration of India and China in the world economy led to the fastest period of wealth creation in the history of humanity with over 400 million people coming out of poverty in China alone. In terms of life expectancy, infant mortality and most metrics of quality of life, there has never been a better time to be alive. However, if you live in Western Europe, the US or Japan today, it sure does not feel that way. The mood is morose and the outlook seemingly dire on almost every front.
I. Where are we, and how did we get here?
A. United States
Since 1980 recessions were mostly caused by central banks increasing interest rates to stave off inflation. The increase in the cost of capital would lead companies and consumers to cut back on their spending, pushing the economy in recession. A combination of expansionary fiscal policy and looser monetary policy would then set the economy back on a growth path led by consumer consumption.
This recession, however, really is different. The continual slashing of interest rates since the abandonment of the Bretton Woods agreements and moving to a Fiat money system has tripled personal debt levels relative to income in the United States. This debt-fueled growth came to an end in the 2008 financial crisis as asset prices, especially real estate prices, fell while liabilities remained at their original values triggering a balance sheet recession.
Faced with the specter of insolvency, over-levered households and corporations focus on repairing their balance sheets by paying down debt. In this environment, monetary policy loses much of its effectiveness: the principal problem is not access to credit, but instead a dearth of demand for borrowing. Thus the playbook that the Fed has run in response to economic downturns ever since the Greenspan era – cut interest rates, encourage consumers to borrow more, and celebrate the comeback in consumption-led GDP growth – breaks down as economic actors reach the limits of their ability to take on more debt. With everyone focused on paying down debt, there is no one to take out more loans.
In light of the lack of unlevered growth opportunities, normal growth won’t resume until the economy has deleveraged. The reality is that we are far from clearing all the imbalances in the economy. Throughout the past 2000 years, financial crises have been followed by sovereign debt crises as countries have nationalized the debts of their banks to avoid the banking systems from collapsing. While preserving their banks as engines of credit creation and economic growth, countries call into question their own ability to finance the debts – thus leading to a sovereign debt crisis. This time has proven no different. We have not deleveraged; we moved leverage from the individual and corporate balance sheets to the government balance sheet and, if anything, we’ve become more levered as the government has borrowed to an unprecedented degree.
Moreover the imbalances that got us into the crisis are far from being resolved. The federal government deficit is clearly not sustainable. Job losses have been far more severe than during any recession since World War II, hampering consumer demand. There is $1 trillion in commercial real estate debt that is underwater and needs to be rolled over in the next few years. Twenty-five percent of households have negative equity in their houses hampering labor market mobility, entrenching unemployment and limiting the demand for loans.
Bank credit creation is still broken. Instead of cleaning up bank balance sheets to allow them to start lending again, we essentially have walking zombies which need to earn themselves back to health. Given that banks make money by the spread between short term rates which they pay to account holders (essentially 0% these days) and the rate they charge for long term loans (e.g., mortgages), low interest rate environments are very profitable for them. However, it will take years for them to earn enough to repair their balance sheets under the current strategy.
In general our policy response has been wrong. We are undergoing short term fiscal retrenchment at every level – federal, state and city at a time of economic weakness without addressing our long term fiscal outlook.
Over the past decade, we have seen a huge misallocation of capital with a disproportionately large share going to real estate. This is not an investment which leads to productivity growth, the ultimate long term creator of wealth. Given that the decline in residential real estate prices has been the root cause of the crisis, the Obama administration seems determined to limit the downwards pressure on prices by reflating real estate through a combination of measures such as first time buyer tax credits and encouraging the Fed to keep interest rates at record lows.
The solution to the bursting of a bubble is not to reflate that bubble! As I wrote in a previous article (Whodunit?), there were many causes for the real estate bubble. One of those was keeping interest rates too low, too long which led to too much risk taking in the pursuit of yield and helped inflate the bubble. Trying to reflate real estate will only continue unproductive capital misallocation and delay reaching the market equilibrium.
While the US still has the privilege of being the reserve currency, it can print money to meet its obligations. However, you cannot print your way to prosperity! Printing will ultimately devalue the dollar. While inflation is not a near term threat given the deflationary pressures on the economy, dollar depreciation is highly likely in the medium to term unless the US addresses its fiscal outlook. (Ironically, the dollar is likely to appreciate in the near term in a flight to the seemingly safest of bad alternatives given the more profound economic problems in the euro zone.)
If Japanese policy makers had to redo the decisions they made over the last 20 years, they would probably focus on cleaning up bank balance sheets quicker. They would be more thoughtful about the spending they did to prop up the economy and would have started working on addressing their long term fiscal outlook earlier.Next time, I'll look at Europe and how they face many of the same problems on a larger and more urgent scale than the US, as well as looking at core differences.