My friend Rob Parenteau says "most professional investors are high frequency macro data and short run asset price driven." He basically means they have no real macro analytical framework to use when making investment decisions. Rob says "it is just a video game for them, where they trace and extrapolate the recent momentum." Rob is talking about recency bias. And I agree 100%. Recency bias was also on display on the way down I might add.
So given the spate of underwhelming macro data coming out of the U.S., you should be asking yourself why is the economy so weak? Answers like "Businesses are losing confidence in the President" or "the tax picture is unclear" will get you gonged. Even the somewhat better "aggregate demand is weak" will get you a "…and the survey says 0." You have to have a macro framework. And that means you have to avoid extrapolating the last batch of macro data and take a 30,000 foot view based on a consistent methodology.
What’s my answer? It’s the debt, silly. Households in the U.S. are up to their eyeballs in debt and this is significant as consumption represents over 70% of U.S. GDP. The U.S. economy is weak because people deep in debt don’t increase spending unless they feel comfortable they can meet their debt repayment schedule through money from income or wealth. So if incomes or asset prices are increasing, people feel safe to take on more debt. But if on aggregate both are stagnant or falling, you get a balance sheet recession. And goosing aggregate demand through stimulus quick fixes is not going to change this – at least, not until the balance sheets have recovered.
The framework I use to discern what this means over the short-to-medium term as well as the long-term is a modified Austrian framework. I’ve shown you this before. The first time was March 2008. The last time was in June when I wrote Why Stimulus Is No Panacea. The point I make connects interest rates to credit growth, debt and bubbles. Mainstream economists like Paul Krugman don’t believe "excessively low policy rates were a key reason for the housing bubble." But he misses the connection between credit growth and changes in monetary policy. When the Federal reserve holds interest rates low for long periods of time, it encourages the accumulation of debt by acting as a tax on savers and a subsidy to debtors. It also lowers risk premia as investors need to reach for yield. This is a boon for high risk projects and is what allowed bad actors like Enron and WorldCom to run amok. But it necessarily means that uneconomic projects are subsidized artificially and specific economic sectors relying on cheap funding are overbuilt.
In the late 1990s I worked in the high yield bond area and saw what low interest rates did to goose interest in telecom infrastructure plays. During the Russian crisis, bonds gapped down and bid/ask spreads widened to where no trades happened in ‘hundred-year flood’ fashion. But after the Fed orchestrated a bailout of LTCM and lowered rates, all was well. Telecom bonds from the likes of NTL, Telewest, Turkcell, and Jazztel dominated the marketplace. When the TMT bubble collapsed in a heap, so did these bonds. Many of these companies needed to be restructured – or, like Iridium, had to be liquidated. These are classic examples of uneconomic ventures and overbuilding due to cheap access to capital.
In the next decade, the Fed continued to goose the asset side of the balance sheet artificially as a solution to the balance sheet problem. Specifically, it targeted asset prices in lowering interest rates. Stock markets were weak well after recession ended in November 2001. So the Fed kept the foot on the accelerator. The result was a major credit bubble with housing at its center.
Raghuram Rajan makes the same point in a recent post:
Ultra-low rates encourage people to borrow to acquire assets, and are partly responsible for both the over-building in housing, the over-indebtedness of households, as well as the over-leveraging of the financial sector. More generally, a subsidy to capital will imply greater capital intensity (and waste) of capital, greater short term leverage, and excessive growth of sectors that rely on either fixed asset investment or credit. Is this the appropriate way to go (especially if we want more labor intensive sectors to grow to provide the jobs that are needed), and is it sustainable?
That’s the key question – sustainability. The household sector debt levels are simply not sustainable. So government pump-priming without reference to debt is a losing long-term proposition. Here’s my thesis for three approaches to this problem from last November:
The only question we have to ask ourselves is whether we want to reduce debt by:
- The Liquidation Scenario. decreasing aggregate demand and precipitating a major depression in order to liquidate zombie companies and malinvestment. This would cause a massive wave of defaults and decrease debt burdens significantly through bankruptcy and debt repudiation. or;
- The Glide Path Solution. increasing aggregate demand by maintaining government spending while trying to liquidate zombie companies and malinvestment. This would allow the private sector to decrease debt burdens significantly over time through increased savings. It also has the benefit of reducing dependency on foreign sources of capital. The downside is a major increase in government debt, the spectre of big government and a long muddle through.
As I have said previously, the Obama Administration is doing neither of the above. It has opted for a third Herbert Hoover solution:
- The Hoover Status Quo. decreasing aggregate demand and precipitating a double dip recession in order to reduce government deficits. This would cause a wave of defaults and decrease debt burdens through bankruptcy and debt repudiation. Meanwhile they will try to prop up zombie companies and maintain malinvestment. This would simultaneously prevent the private sector from decreasing debt burdens through increased savings and maintain dependency on foreign sources of capital – all without ending the spectre of big government.
I have advocated the glide path solution. But I see the liquidation scenario as much better than the present path – especially since, with the present course, we are witnessing crony capitalism on a massive scale. The problem with the liquidation scenario is a lower standard of living and the prospect of geopolitical tension, social unrest, poverty, and war.
The Herbert Hoover solution we are now using leads to a Japanese outcome at best or a Great Depression outcome at worst.
You should recognize the first solution as the one the Greeks, Irish and the British are trying – an Austerian one (a term invented by my friend Rob Parenteau, who I referenced at the outset, by the way). The second solution is the one I have advocated for the US. The third solution is my least preferred outcome and is the path we are presently on (President Obama has now reversed himself and has backed away from his anti-deficit approach). The approach is heavily biased toward the status quo but is also politically unsustainable as I pointed out at the end of my "not a recession but a depression" piece.
With this macro background, where does that leave us today?
- With still weak job and income growth. (Consumer Spending -Income impact)
- With a 12-month supply of existing homes and still elevated home price to income ratios. (Consumer Spending – wealth impact)
- With still indebted consumers still near peak debt service to income ratios. (Consumer Spending – debt impact)
- With a large and politically unsustainable budget deficit and a declining addition from stimulus already in the pipeline. (Fiscal Policy)
- With a Fed chastened by its foray into fiscal policy and near zero interest rates that leave no way to stimulate via rate cuts. (Monetary Policy)
Consumers are dead in the water. Fiscal policy is also dead unless Obama opts to extend the Bush tax cuts. The monetary authority always acts last, plus the Fed is out of bullets on rates and so it’s not going to get funky here by conducting fiscal policy until recession actually hits. Residential investment is going to be weak with so much existing home inventory. So that leaves a pick up in non-residential business investment or exports over imports to lead us out of this recession.
I have said previously I expected 1-2% growth at best in the second half of this year. Given the data I am seeing now, I would revise that to 0-1% at best. And since we’re hanging our hat on trade (where things are deteriorating) and on business investment, the risk is clearly to the downside.
That’s why the U.S. economy is weak and why it will be weak for some time to come.