Macro Factors and their impact on Monetary Policy,
the Economy, and Financial Markets
MacroTides.newsletter-AT-gmail.com
Investment letter – June 22, 2011
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Balancing Global Imbalances
In some respects, the global economy is in a more precarious position than it was in early 2009. Two years ago, governments around the world were still capable of unleashing trillions of dollars in fiscal stimulus. Central banks were able to slash interest rates, and in the case of the European Central Bank and Federal Reserve, force feed additional trillions of dollars of liquidity into their respective banking systems. The initial goal was to stabilize the global financial system, and subsequently engineer a self sustaining economic recovery in each of their country’s economy.
The results have been uneven. In the United States, GDP growth has been roughly half the average of post World War II recoveries, so the question of whether a self sustaining recovery has taken hold is debatable. Although Germany and France have fared relatively well, the same cannot be said for Greece and Ireland, whose economies are still contracting. Spain, Portugal, and Italy are barely growing, with Spain sporting an unemployment rate of 21%. In order to right its fiscal house, Britain has adopted a stiff austerity program that proposes to cut government spending by more than 20%. In the short run, the decline in government spending will weigh on growth. Japan will rebound from the earthquake/tsunami plunge in GDP, but the rebound will fade into the moribund growth that has plagued the Japanese economy for two decades. On the flip side are China, Brazil, and India, where the combination of fiscal and monetary stimulus succeeded too well, and has led to a bout of real inflation.
The United States, European Union, Japan, and Great Britain account for 62% of global GDP. To varying degrees, these developed economies share a number of common traits that will retard growth for the foreseeable future. Demographically, they have aging populations, which will increasingly stress the social safety nets in each country. Most have a relatively to high debt to GDP ratio, that will slow economic growth in coming years. Slower growth means weaker income growth, so interest payments on their debt will absorb a greater share of total income and leave less for spending and saving. Not the best prescription for long term economic growth.
China, Brazil, and India comprise 15% of world GDP. While each of these countries will continue to enjoy above average growth relative to the developed economies, they are now confronting rising inflation with tighter monetary policy. This will surely lead to a slowdown in their economies in the second half of 2011. Since monetary policy is conducted by looking in the rear view mirror of economic statistics, there is the risk that each central bank may tighten a bit too much, resulting in a deeper slowdown than desired.
Balance is a state in which an object or opposing forces remain steady, while resting on a base that is narrow relative to its other dimensions. Visualize an upside down pyramid, whose tip is balanced on a narrow beam. The object is debt, and the narrow beam is global GDP growth. Given the uncertainty and challenges facing the global economy, the narrow beam may be suspended over an abyss. The pyramid will tip, if global growth isn’t strong enough to support the debt burdens of the developed counties, or if tighter monetary policy slows China, Brazil, or India’s economy too much. If another tipping point is reached, it could prove more devastating than the financial crisis of 2008, since the fiscal and monetary wells are dry. The odds are not comforting, since policy makers in the U.S. and Europe are still operating with the same playbook that got us into this mess in the first place. The banks that were too big to fail in 2008 are even larger today, and the opacity of derivatives remains impenetrable. The business cycle will never be repealed by spendthrift politicians or accommodating central bankers.
The U.S.
Between 1985 and 2008, household debt as a percent of disposable personal income more than doubled, rising from 62% to 135%. At the end of 2010, the ratio was 120%, still well above the 89% it averaged in the 1990’s. The average household would need to cut $26,172 of debt to get back to 1990’s levels. More than half of the $500 billion decline in household debt since 2008 has been the result of defaults on mortgages, credit cards, and auto loans. This ‘improvement’ has come at the expense of lenders, rather than from consumers paying off debt from income gains. It would have been far healthier if the ratio was declining due to solid gains in disposable income. Unfortunately, just the opposite has occurred. According to the Commerce Department, real private sector wages have increased just 4.2% over the last decade. The last 10 years have been the weakest period by far since 1940. For most of the past 35 years, the 10 year gain in real wages has averaged more than 25%. This is the first recovery since World War II that there has been no gain in wages and salaries during the seven quarters after a recessions end.
According to the Federal Reserve, homeowners took out a total of $2.69 trillion of equity in their homes between 2004 and 2006. Coupled with the weak growth in incomes since 2001, this extraction of home equity is the primary reason why household debt as a percent of disposable income soared between 2002 and 2007. As consumers spent most of the $2.69 trillion of equity they pulled out of their homes, GDP growth was stronger in those years than it otherwise would have been. Going forward, the debt induced growth in GDP during the housing bubble years will not only be missing, but now consumers have to service and pay down that debt, which will prove an additional drag on their spending and GDP growth.
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