Monday, August 8

An inconvenient economic truth

There is nothing new in the latest statistics coming out of the USA over the last month or so nor does Standard & Poor’s decision last Friday to strip the U.S. of its AAA credit rating for the first time alter much how US debt will be viewed. Nevertheless the move compounded fears around the globe including Australia which saw one of the worst slumps in share prices seen since the onset of the global financial crisis in 2008 and severe volatility is likely to continue with further massive losses to continue.Currently a high degree of skepticism exists in relation to rating agencies generally given their abysmal performance prior to the GFC but this did not stop investors dumping stock in what could be described as severe panic selling. The move has helped cement a previous wall of worry about European debt worries and add weight to the fears another double dip recession will occur.

But strangely enough in currency markets there has been if anything a return to favour to the US dollar which caused the Aussie to be dumped. Hence money parked conveniently in equities in Austrlia has been realised in aggressive selling which has unnerved many long terms investors unable to comprehend the reason behind this sell off at depressed prices. Once again we have the spectacle of manipulation by Hedge funds and speculators which is not helpful to long term stability.

Aggregate debt levels in the USA have not fallen despite massive deleveraging by the private sector

Although householders in the USA have reduced their liabilities to disposable incomes from 130% to 112% since the GFC this still compares unfavorably to long term median averages below 70 %, as the loss in equity in falling house prices and continuing defaults leave many in distress. There remains a downward pressure on house prices which hopefully will soon stabilize as supply and demand come into equilibrium by the end of the year or maybe in the first half of the next year. There was a mild pick up in housing construction which gives some ray of hope that the worst of the oversupply in housing stocks may be nearing an end. Furthermore Corporations have reduced their debts and many have recapitalized to ensure much stronger Balance Sheets. But demand in a weak economy is still insufficient for any marked pick up in hiring sufficient to reduce the current high levels of unemployment. Hence the depressing prospect remains that many disenchanted well qualified workers are unable to secure positions. All of this adds up to a continuation of substantial deleveraging which would have resulted in a sizeable reduction to the overall debt but has been offset by huge budget deficits. So overall there is not much difference in the overall level of total debt since the global financial crisis.

Is the downgrading in debt justified and what is the effect of deleveraging in a weak economy?

I think the downgrade for government debt by Standard &Poor’s can only be justified on the basis of concern that the political will does not seem to exist to rationally determine a sensible future policy. But in reality treasuries seem unaffected and intially even ralled (a rally increases the face value of those securities which in turn reduces the interest yield) so that it is almost a non event as investors remain unconcerned. The flood of equity sales into treasuries will augment this outcome even though it does not make a lot of sense to me - but then markets are not rational in the short term but driven by sentiment rather than logic. Only in the longer term when things settle down will fair values emerge.Hence I do think the reaction globally is clearly overdone. It is of course of historic interest and concern but I for one remain ambivalent to the machinations within just one agency that prompted this call.

However I do think they have a point about the poor response to the debt crisis by politicians. In an economy that only collects about 15% in tax revenues from GDP and spends 25% to make up a deficit of 10% the opportunity to formulate a sensible compromise seems fairly straightforward.
A combination of much needed fiscal reform ultimately leading to a higher rate of tax for those who can afford it (and who incidentally history tells us are not going to suddenly stop spending) with sensible long term spending curtailment seems rather obvious.

An inconvenient economic truth


The reality is that deleveraging still has a long way to go before sustainable debt levels can eventually be secured. History tells us that emerging from a financial crisis takes much longer that the recovery from a recession. The effects of a financial crisis and that of the size last experienced can last up to a decade before normality returns in terms of unemployment and so forth. Hence any sudden measures implemented to further underpin reductions in public debt risks sending another shock wave into the economy. It is hard to see anything other than continued low or anemic growth patterns for a number of years but this is far preferable to a recession.

The so called green shoots that appeared previously will reappear but they will not signal a strong sustained growth but rather a slow sector improvement ( house construction possibly soon to recover)whose pace nevertheless will be restrained by the effects of deleveraging of debt curtailing the supply of private credit. Presently you have a double whammy of both private and public debt remaining well over long term averages and sustainable levels. Growth for the past several decades was fueled by excessive credit growth and when you go unto reverse naturally enough you lose that momentum. The devaluation of the dollar does make exports more competitive but this sector is too small to offset the much larger domestic contraction.

Policy settings & Conclusion

Policy in my view requires a measured approach to bring about gradual reductions in both the private and public sector debt coupled with moves to engender confidence combined with improved corporate governance to help quell the fears of another recession.

Another vital point that does not seem to warrant much discussion is that given the massive deleveraging that must occur we are only at best beginning this cycle and need to be mindful of the effect of adding too much too soon to the current credit contraction.

Cutting back drastically on government spending to balance the budget in the short term will almost certainly plunge the country into a severe recession. Curtailing future benefits can undermine confidence - particularly if numbers are thrown around as if they were hurriedly written down on the back of an envelope.

Nevertheless desite al of this and deleveraging in the private sector many firms are capable of producing good returns and,for the most part corporates have been involved in recapitalization as was previously mentioned. Hence we may eventually see a strong rebound in stock markets but this will not be a signal the economy is about to take off. Rather firms my still be able to offer good returns but many will reamain restrained by the debt overhang.
It’s no time for politics at this time in history yet politics and extreme ideologies currently rule the roost.

If you would like read a more comprehensive view on deleveraging after a global financial crisis from the Economist click here.

3 comments:

susan said...

Hi Lindsay,
This is a very well thought out and considered evaluation of the current financial circumstances. I wish I believed that things would clear through the efforts of sober and principled professionals.

However, the rating agencies are corrupted. The point was to blame lack of new taxes.

The US can't implement new taxes without crashing the tax base unless they accelerate monetization, in which case real tax receipts will fall. I'm not sure if this is a tragic mistake or exactly what they wanted.

"And remember, where you have a concentration of power in a few hands, all too frequently men with the mentality of gangsters get control"
~ Lord Acton

Lindsay Byrnes said...

Hi Susan,

Thanks for your comment. As I alluded to in my post what has happened is that long term bond yields have continued to slide in the face of a minor rally. Investors seem willing to provide the US government with 10 year funding at a yield that doesn’t even cover inflation- it is hard to believe but that is the reality. The US 10 year Note yield is now hovering at a 40 year low and may even go lower.

Hence if the US government debt burden was about to become a real threat to the broader economy, interest rates (or yields) would have risen not fallen to see a result similar to what has occurred in Greece, Portugal etc. The fact they have fallen rather than spiked gives short shift to the fears of an imminent fiscal “crisis”. What it really indicates is a stagnant economy which not going to grow much until the debt overhang reduces to a more sustainable level.

Restoring equity and reform into the tax situation in my view is not all that complicated. It is interesting to note the Bush tax cuts expire across all tax brackets on January 1, 2013- and they are worth about $3.6 trillion over 10 years. Before those tax cuts the US was already a low tax country. If all else fails and that kicks in from 2013 that would actually start to reduce the debt in a timely fashion.
Best wishes

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