Gross: ‘The global economy is suffering from a lack of aggregate demand’

Bill Gross’ latest investment monthly is out. His view is that consumer retrenchment is the real problem behind all of the worries for the global economy and the US in particular.

He writes:

The global economy is suffering from a lack of aggregate demand. In simple English that means that consumers are not buying enough things and that companies are not hiring enough people because of it. Growth slows down, especially in developed as opposed to developing countries, and the steel mills of Allentown, USA and Sheffield, England close down.

This shortfall of global demand is a nearly impossible concept to grasp amongst politicians and their citizenry. Don’t people always want to buy more things and isn’t demand theoretically insatiable? [emphasis his]

His conclusion is that the politicians do realise this and demand is insatiable but that the debt overhang is simply too large to overcome. He says a shortfall in aggregate demand is exactly what happens when a "family’s credit card gets maxed out". Mind you things are going gangbusters in places like Brazil, India and China. But the reality is that the emerging economies simply do not have enough aggregate demand to make up for the shortfall due to the developed economies’ private (and now public) sector indebtedness. Why?  In Gross’ view much of this is a relic of the severe Emerging market crises we witnessed a decade ago in the late 1990s and early 2000s.

Their financial systems are still maturing and reminiscent of a spindly-legged baby giraffe, having lots of upward potential, but still striving for balance after a series of missteps, the most recent of which was the trio of the 1997–98 Asian crisis, the 1998 Russian default and the 2001 Argentine default. And so their policies are oriented towards export to debt-laden developed nations instead of internal consumption, leaving a gaping hole in global aggregate demand. China is a locomotive to be sure, but it cannot pull the global economy uphill on the basis of mercantilistic exports alone. It needs to develop many more of its own shopping malls and that will take years, if not decades.

My question is: What next then? Do we put put along in slow growth mode, muddle through until balance sheets are repaired? My argument has been – and still is – that this is not a likely outcome.

There are four ways to reduce real debt burdens:

1. by paying down debts via accumulated savings.
2. by inflating away the value of money.
3. by reneging in part or full on the promise to repay by defaulting
4. by reneging in part on the promise to repay through debt forgiveness

Right now, everyone is fixated on the first path to reducing (both public and private sector) debt. I do not believe this private sector balance sheet recession can be successfully tackled via collective public sector deficit spending balanced by a private sector deleveraging. The sovereign debt crisis in Greece tells you that.  More likely, the western world’s collective public sectors will attempt to pull this off. But, at some point debt revulsion will force a public sector deleveraging as well.

And unfortunately, a collective debt reduction across a wide swathe of countries cannot occur indefinitely under smooth glide-path scenarios. This is an outcome which lowers incomes, which lowers GDP, which lowers the ability to repay. We will have a sovereign debt crisis. The weakest debtors will default and haircuts will be taken.  The question still up for debate is regarding systemic risk, contagion, and  economic nationalism because when the first large sovereign default occurs, that’s when systemic risk will re-emerge globally.

–The origins of the next crisis

What we are witnessing in Europe now is certainly testament to my thesis. Gross agrees with the crucial point about economic nationalism, writing that "[w]ith insufficient demand, nations compete furiously for their share of the diminishing global growth pie. All look to borrow growth from somewhere else." This is what the so-called currency wars are all about, what I have called ‘stealing growth’  but Gross labels ‘borrowing growth’ in his essay. However, this describes the developed world. In Gross’ view the real problem is a lack of competitiveness in the developed economies and a paradigm shift toward the emerging economies. He says the developed world has become Allentown writ-large.

The solution for more jobs is seen as a simple quick step of extending the Bush tax cuts or incenting small businesses to hire additional workers, or in the case of Euroland, shoring up government balance sheets with emergency funding. It is not. These policies only temporarily bolster consumption while failing to address the fundamental problem of developed economies: Job growth is moving inexorably to developing economies because they are more competitive. Free trade and open competition, like a stretched rubber band, have snapped the US and many of its Euroland counterparts in the face. By many estimates, Chinese labour works for 10% or less than its American counterparts. In addition, and importantly, it is able to innovate as quickly or replicate what we do. Jobs, in other words, can never come back to the level or the prosperity reminiscent of 1960s’ Allentown, Pennsylvania until the playing field is levelled.

This shift has been ongoing for some time. Over the past decades in the US, the UK and Ireland, much of the burden has been ameliorated by taking on financial services as the service economy replacement for lost manufacturing jobs. These economies have been financialised. The Germans, on the other hand have tried to compete by moving up the curve to more value added services, products and manufacturing. In Gross’s view, the German model is one of the potential long-term solutions to the global aggregate demand scarcity problem. The other more sinister solution is that of economic nationalism, protectionism, trade barriers, and so on.

It is by far the less preferable route, but unfortunately the one that is easier and, therefore, most politically feasible. Politicians do not get elected on the basis of “sacrifice.” They get elected by pointing to foreign demons, be they in the Middle East or in Asia. The Chinese yuan is a far easier target than the American workers earning ten times their Chinese counterparts and producing an inferior product to boot.

Clearly, the US is taking the low road here, what Gross calls "Easy Street".

We will more than likely continue to “level the playing field” via currency devaluation and an increasing emphasis on trade barriers and immigration, as opposed to constructive policies to make this country more competitive in the global marketplace.

Exactly. The upshot of this is that investment opportunities will be more limited in the US as a result. Gross, like Jeremy Grantham, says the smart money is selling out of US assets and moving to the Emerging economies.

Source: Allentown, Bill Gross – Pimco Investment Outlook, December 2010