an updated version of a post I wrote about two-and-a-half months
ago over at Credit Writedowns. When I wrote it, I had been looking
for bullish data points as counterfactuals to my bearish long-term
outlook. I found some, but not nearly enough.
year, I wrote a post u201CWe
are in depression,u201D which called the ongoing downturn a depression
with a small u201Cd.u201D I was optimistic that policymakers could engineer
a fake recovery predicated on stimulus and asset price reflation
— and this was bullish
for financial shares if not the broader stock market. But,
we are witnessing temporary salves for a deeper structural problem.
So my goal
was to find data which disproved my original thesis. But, I came
away more convinced that we are in a tenuous cyclical upturn.
This post will discuss why we are in a depression, not
a recession and what this means about likely future economic and
investing paths. I pull together a number of threads
from previous posts, so it is pretty long. I have shortened it
in order to pull all of the ideas into one post. So, please read
the linked posts for background as I left out a lot of the detail
in order to create this narrative.
here then with the crux of the issue: debt.
recession rooted in structural issues
Back in my
first post at Credit Writedowns in March 2008, I said that the
U.S. was already in a recession, the only question being how
deep and how long. The issue was and
still is overconsumption i.e. levels of consumption supported
only by increase
in debt levels and not by future earnings. This is the core
of our problem — debt.
I see the
debt problem as an outgrowth of pro-growth, anti-recession macroeconomic
policy which developed as a reaction to the 1970s lost decade
trauma in the U.S. and the U.K.. The 70s was a low growth, high
inflation ride that generated poor market returns. The U.K. became
the sick man of Europe and labor strife brought the economy to
its knees. For the U.S., we saw the resignation of an American
President and the humiliation of the Iran Hostage Crisis.
after the inflationary outcome that many saw as an outgrowth of
the Samuelson-Keynesianism of the 1960s and 1970s, the Reagan-Thatcher
era of the 1990s ushered in a more u2018free-market' orientation in
macroeconomic policy. The key issue was government intervention.
Policy makers following Samuelson (more so than Keynes himself)
have stressed the positive effect of government intervention,
pointing to the Great Depression as animus, and the New Deal,
and World War II as proof. Other economists (notably Milton Friedman,
and later Robert Lucas) have stressed the primacy of markets,
pointing to the end of Bretton Woods, the Nixon
Shock and stagflation as counterfactuals. They point to the
Great Moderation and secular bull market of 1982-2000 as proof.
This is a divisive and extremely political issue, in which the
two sides have been labeled Freshwater and Saltwater economists
(see my post u201CFreshwater
versus saltwater circa 1988u201D).
just as the policy of the 1950s to the 1970s was not really Keynesian
(see what Richard Posner says about Keynes'
General Theory and you will see why), the 1980s-2000 was not
really an era of u201Cfree markets.u201D I call it deregulation
as crony capitalism. What this has meant in practice is that
the well-connected, particularly in the financial services industry,
have won out over the middle classes (a view I take up in u201CA
populist interpretation of the latest boom-bust cycleu201D). In
earnings peaked over 35 years ago in the United States when
adjusting for inflation.
was a difficult period in which the U.K. and the U.S. saw jobs
vanish in key industrial sectors. To stop the rot and effectively
mask the lack of income growth by average workers, a new engine
of growth had to be found. Enter the financial sector. The financialization
of the American and British economies began in the 1980s, greatly
increasing the size and impact of the financial sector (see Kevin
Phillips' book u201CBad
Moneyu201D). The result was an
enormous increase in debt, especially in the financial sector.
problem was made manifest repeatedly during financial crises of
the era. Not all of these crises were American — most were abroad
and merely facilitated by an increase in credit, liquidity, and
international capital movement. In March 2008, I wrote in my third
post on the
US economy in 2008:
very beginning, the excess liquidity created by the U.S. Federal
Reserve created an excess supply of money, which repeatedly
found its way through hot money flows to a mis-allocation of
investment capital and an asset bubble somewhere in the global
economy. In my opinion, the global economy continued to grow
above trend through to the new millennium because these hot
money flows created bubbles only in less central parts of the
global economy (Mexico in 1994-95, Thailand and southeast Asia
in 1997, Russia and Brazil in 1998, and Argentina, Uruguay,
and Brazil in 2001-03). But, this growth was unsustainable as
the global imbalances mounted.
the debt burdens became too large and resulted in the housing
meltdown and the concomitant collapse of the financial sector,
a problem that our policymakers should have foreseen and the reason
blog is named Credit Writedowns. Make no mistake, the housing
and writedown problems are only symptoms; the real problem is
the debt — specifically an overly indebted private
sector (note the phrase u2018private sector' as I will return to this
is a depression, not a recession
is the real issue underlying an economic downturn, the result
is either Great Depression-like collapse or a period of stagnation
and short business cycles as we have seen in Japan over the last
two decades. This is what a modern-day depression looks like —
a series of W's where uneven economic growth is punctuated by
fits of recession.
recession is merely a period of recalibration after businesses
get ahead of themselves by overestimating consumption demand and
are then forced to cut back by making staff redundant, paring
back inventories and cutting capacity. Recessions can be overcome
with the help of automatic stabilizers like unemployment insurance
to cushion the blow.
is another event entirely. Back in February, I highlighted a blurb
from David Rosenberg which summed up the differences
between recession and depression pretty well.
are typically characterized by inventory cycles — 80% of the
decline in GDP is typically due to the de-stocking in the manufacturing
sector. Traditional policy stimulus almost always works to absorb
the excess by stimulating domestic demand. Depressions often
are marked by balance sheet compression and deleveraging: debt
elimination, asset liquidation and rising savings rates. When
the credit expansion reaches bubble proportions, the distance
to the mean is longer and deeper. Unfortunately, as our former
investment strategist Bob Farrell's Rule #3 points out, excesses
in one direction lead to excesses in the opposite direction.
The day after
I highlighted Ray
Dalio's version of this story which added some more color.
Notice the part about printing money and devaluing the currency
if the debt is in your own currency.
go through a long-term debt cycle – a dynamic that is self-reinforcing,
in which people finance their spending by borrowing and debts
rise relative to incomes and, more accurately, debt-service
payments rise relative to incomes. At cycle peaks, assets are
bought on leverage at high-enough prices that the cash flows
they produce aren't adequate to service the debt. The incomes
aren't adequate to service the debt. Then begins the reversal
process, and that becomes self-reinforcing, too. In the simplest
sense, the country reaches the point when it needs a debt restructuring…
happened in Latin America regularly. Emerging countries default,
and then restructure. It is an essential process to get them
go through a giant debt-restructuring, because we either have
to bring debt-service payments down so they are low relative
to incomes – the cash flows that are being produced to
service them – or we are going to have to raise incomes
by printing a lot of money.
complicated. It is the same as all bankruptcies, but when it
happens pervasively to a country, and the country has a lot
of foreign debt denominated in its own currency, it is preferable
to print money and devalue…
Reserve went out and bought or lent against a lot of the debt.
That has had the effect of reducing the risk of that debt defaulting,
so that is good in a sense. And because the risk of default
has gone down, it has forced the interest rate on the debt to
go down, and that is good, too.
the reason it hasn't actually produced increased credit activity
is because the debtors are still too indebted and not able to
properly service the debt. Only when those debts are actually
written down will we get to the point where we will have credit
growth. There is a mortgage debt piece that will need to be
restructured. There is a giant financial-sector piece –
banks and investment banks and whatever is left of the financial
sector – that will need to be restructured. There is a
corporate piece that will need to be restructured, and then
there is a commercial-real-estate piece that will need to be
are we, then? We are in a fake recovery that could last as long
as three or four years or could peter out very quickly in a double
dip recession. You may have seen my April post on the
fake recovery. Read it. I won't cover that ground here. However,
I will highlight how I came to believe in the fake recovery and
how asset prices have played into this period (the S&L crisis
played out nearly the same way). I see writedowns as core to the
transmission mechanism of debt and credit problems to the real
economy via reduced supply and demand for credit. Again, this
is why my site is called Credit Writedowns.