More thoughts on the global recovery

This is going to be a brief post as the Thanksgiving holiday in the US nears. I will be off today and Thursday and will not post. I may have some comments on Friday. Here I just wanted to extend my thought process yesterday toward a more upbeat thinking.

The gist of yesterday’s post was that we are in the middle of a global cyclical upswing in which all of the main world economies are n recovery. The US, Europe, China and India in particular are experiencing economic growth to varying degrees. And all indications are that this growth will continue for the foreseeable future. Aiding growth in Europe and the United States is monetary expansion. But when and why will this expansionary phase end and what will the outcome be?

Yesterday, I said that, “I tend to believe this ends badly, in credit writedowns, deleveraging, bankrupticies, and the attendant civil unrest.” The case I have been making here at Credit Writedowns for the past five odd years is that private debt accumulation as a result of asset price inflation leaves those with the highest levels of debt relative to income in a vulnerable situation when a cyclical downturn hits. My view since the beginning of the financial crisis has been that policy levers to alleviate this private debt stress are limited, and that this limitation will be felt in defaults, writedowns and deleveraging of a magnitude that is larger than usual for a cyclical downturn. Hence, the name of this blog. 

This view has been validated by events but now we are in a recovery. And so the question is why that view necessarily holds now that the crisis has past.

The key to why a negative outcome would result is high private debt. If the servicing costs of that debt are larger than income for a large enough group of debtors it creates a liquidity crisis that turns into a solvency, financial and economic crisis. But perhaps this outcome can be avoided. Here are three means to do so, one positive and sustainable, the others much less so.

  • Wage growth. First, if the global recovery lasts long enough, perhaps private debts can be reduced relative to the size of the economy. For example, if the recovery in the US turns into a wage and jobs recovery that spurs consumption as a result of wage growth then those increased wages can underpin larger levels of household debt because interest rates are low, bringing debt service costs to multi-decade lows. Even if interest rates were to rise, an increase in wages could offset the rise and even in that case we would have to see a tremendous increase in rates for debt service costs to return to the levels prevailing pre-crisis.

  • Exchange rate decline. US policy could target the exchange rate as Japanese monetary policy implicitly does. The Swiss put in a ceiling for the Franc versus the Euro and this has kept the Franc from appreciating further. However, that would not be enough to sustain growth and turn around the US current account. The US would need to employ a more aggressive strategy aimed at promoting higher inflation and flooding the markets with dollars. One possibility would be for the Fed to buy euros and Yen on the open market in order to drive up their price. It isn’t clear, however, what political justification the Fed could give for doing so or whether taking on assets not based in US dollars would be a wise idea. Instead the Fed could turn to monetary easing by buying up US dollar assets in the hopes it could spur a decline in the US dollar. That easing would also help in dislocated markets discussed in the bullet below.

  • Extraordinary monetary ease. When the Fed hit the zero lower bound, it was out of ammo on its traditional guiding monetary policy tool. Therefore, it came up with two other tools, forward guidance and quantitative easing, in order to fill the gap. Quantitative easing in particular was very instrumental in underpinning mortgage-backed security asset prices when the financial crisis hit. The Fed could attempt to do the same again but much more aggressively this time – buying municipal bonds in addition to the mortgage-backed securities and Treasurys. The Fed could also engage in rate easing by explicitly targeting a rate at which it would buy, rather than proposing to buy as much as it could at the going market rate.

This is just a short look at three possibilities. The first is sustainable though unlikely in my view. The second is equally unlikely, especially without a crisis, and it is unwise given the foreign exchange assets. The third has been done, but on this scale it would be both reckless and unlikely outside of a crisis.

Without both job and wage growth, I don’t see this heading for a positive outcome. What’s clear then is that the lack of a fiscal option leaves the US economy in a bind. And when I say ‘fiscal option’, I don’t mean bailouts, bridges to nowhere, cash for clunkers or the like. Rather, I am thinking about something like government-led or government-sponsored capital investment. If the US had an infrastructure rebuilding policy or some other fiscal policy that promoted wage and job growth, that would dovetail nicely with the first bullet above and would support the tax base such that the effect on deficits would not necessarily be negative. Fiscal policy aimed at wage and job growth looks like the only real option here. I have some ideas on this front that I have been toying with. But fiscal is off the table from what I see, at least until the next downturn hits.

Happy Thanksgiving to you all, if I don’t write before then.

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