The Economy in the United States and the United Kingdom

Quick note here on the US and the UK to change things up a bit from the Cyprus obsession. Before I start I want to alert you that I will be on holiday/vacation in Germany for the next two weeks and so I won’t be able to write a lot during that time. I won’t even be near a computer a lot of the time so I can’t be sure how much I will write. Now, let’s move on the the US and the UK.

A couple of years ago I wrote something along the lines of “the US and the UK are a perfect experiment for how stimulus and austerity work.” Let me stop here and find the article so I can give you the exact quote. Ok, here it is (with emphasis added):

“The UK and the US are remarkably similar in their heavy dependence on financial services and the housing bubbles which preceded crisis. The similarity is greater when one looks at the initial political response in terms of deficit spending in both countries, double digit percentages of GDP. In the UK the budget deficit was a massive 11.4% of GDP in the last fiscal year. In the U.S., the federal deficit for the fiscal year ended September 2010 was $1.294 trillion or 8.9% of GDP, down from FY 2009′s 10%. Both countries have their own national currencies and central banks that have engaged in quantitative easing to support the economy. And both countries have very low interest rates despite massive deficits, unlike deficit spenders in the Eurozone without national currencies where national solvency is a gripping concern.

“In many ways, this budget-busting spending makes sense due to the huge shortfall in private sector demand as the private sector contracted and tens of millions were thrown out of work. If government had countered this contraction in the private sector with one of its own, a Great Depression was sure to come. An appreciation of the financial sector balances makes this clear. That’s what I was talking about in October of 2009 with “Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip”. “

“But since that time, the US has resisted austerity while the UK has embraced it. In my mind, this is the best real-time economic experiment we can have on what does and doesn’t happen as a result of government spending. Personally, I think the budget deficits in the U.S. are unsustainable and I have written at length as to why. Nevertheless, I recognize that the large majority of the deficit in the U.S. has been driven by an output gap due to massive un- and under-employment.”

That was from January 2011. So let me see if I can use this as a jumping off point for the developments in the UK and the US. Recently, Tim Duy wrote up a good piece on the US recovery that I recommend. He said the recovery is real and went on to prove why he thinks it’s real. I think he makes very good points and I agree with him that the macro fundamentals of the US economy are pretty good, though the recovery is slow and the jobs picture is still not where we want it to be. That’s what I have been saying for a number of onths now. After the US turned in a negative GDP print in January for example I wasn’t worried at all because “core personal consumption expenditures are humming along at a good clip, having risen 1.5%. Final sales in the private sector grew at an annualised 3.3% pace. That’s the fastest in at least 3 quarters. So I think this makes the case for the underlying fundamentals being strong. We should get confirmation that employment growth is adding to this via the jobs number on Friday.”

As I intimated in the 2011 piece above and said directly in January, what has concerned me was the political sustainability of large fiscal deficits. I have always said austerity would ensue as a result and indeed it finally has. But while I have been making the macro case for the last four years that this would lead to recession, I am not sure this is the case. As I admitted two weeks ago on continued recovery in the US, the cyclical forces now at play are pretty powerful. It’s early days yet, but I would not count on the sequester and the fiscal clifflet derailing this housing-led recovery.

In contrast, just as I said in 2011, the austerity in the UK has led to poor growth. None of the pundits I respect have said anything positive about the new budget Osborne presented this week. Roger Bootle panned it. Elsewhere in the Telegraph, they said it could lead to a bubble. Even Alaistair Darling couldn’t help getting in a good dig. Everyone hates this budget. And for good reason; the UK is going to continue with the same policies that have not worked for the past two years. Instead of allowing fiscal policy to work or simply leaving things alone, Osborne is going for austerity and relying on housing gimmicks and monetary policy to bail him out. He’s even calling for more QE, thinking that a combination of housing gimmicks and QE can get a debt-fuelled economic boom going again.

Here’s the thing though. If policy is easy enough it could actually work. Look at what’s happening in the US. I talked to an old colleague of mine who is still in the leveraged finance and private equity business I left more than a decade ago. He told me that PE fund size is shrinking but deal multiples are sky high. He said all of the hallmarks of the bubble days like high debt /EBITDA multiples and light covenants – known in the business as ‘cov light deals’ – are back with a vengeance. based on these metrics, you would think it was 2006, he said. That tells you something. As I said with smaller US banks reaching for yield, zero rates do alter private portfolio preferences.

Tim, to his credit has these worries too. He writes:

“Caution: Pure speculation follows. If this recovery is built on an asset bubble (and I am starting to entertain a possibility that I had previously discounted, that it could be a joint equity/housing bubble), then I suspect we will learn after the Fed tightens policy that we are not off the zero bound. If so, I further suspect the next recovery will require the Fed to deliver a pure-helicopter drop of money.

Bottom Line: The US economy is less fragile than commonly believed; it has endured a series of shocks over the last three years without major incident. I am claiming neither that equity prices won’t stumble, nor that we should be happy with the pace of activity. But I do think that a recession is unlikely before the Federal Reserve begins raising interest rates – something not likely to happen for two years. While long-run predictions are dangerous, for the sake of argument add up to another two years for tighter policy to reverberate through the economy and you are looking at sometime around 2016/2017 when the next recession hits. That’s the timeframe I am currently thinking about.”

That’s nearly how I see it, though I am still looking to see if we have a recession this year. One thing I am toying with is the concept that we have entered a Japanese scenario where zero rates are permanent – which is why I coined the phrase ‘permanent zero’. In that event, we don’t need necessarily the central bank to raise rates. Perhaps, the economy founders on its own without central bank action. Only time will tell. But, truth be known I think this recovery is for real too. The threat of austerity can always bring down the US and has already brought the UK down. Our worry here has to be asset bubbles because, while things look good now, the overheating in asset markets is already well-advanced.

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