by: Roman Scott (Seeking Alpha)
The problem with this model is that public demand steps in to substitute for private demand, and public debt takes over from private debt. In short, the problem is nationalized for the long term.
The G3 have just done exactly that. This creates two key risks. Firstly, the threat of potential long term inflation and debt repayment burdens when growth recovers, as governments have to raise interest rates to ensure demand for public debt is sustained. As soon as private demand returns, private sector investment and demand for credit returns with it. The sea of government debt has to compete. Meanwhile, the national currency has been weakened by the deterioration in state finances, damaging the attractiveness of their debt to foreigners if they smell a depreciating holding currency. In short, investors have better things to be buying, and higher rates are the only inducement. This was Britain in the seventies.
The second risk is the opposite - a market of damaged consumers who shift to saving and reducing credit rather than spending, creating a deflationary spiral in a world with far too much capacity for just about everything. The economy stagnates, continuously flirts with deflation, and piles on more public debt as the state regularly tries another stimulus package to persuade weak consumers to spend. Over time, it takes more and more public debt to produce less and less GDP growth, with fewer real jobs. Consumers work out that the public debt is actually their long term liability, and turn even more cautious. The only hope for limited growth then becomes exports. It is the economic equivalent of permafrost. This was Japan in the nineties. This remains Japan now, twenty years after its own GFC in 1989.
Both of these scenarios are real risks, hence a lot of the confusion in the markets and in asset buying patterns. I don’t have the space to go into a discussion of the merits of both arguments. And given the state of flux in the economy at present, either scenario is plausible. So I will instead focus here on where my views are at present.
I worry much more about deflation than inflation risks now, and will for at least the next two to three years. By inflation risks I mean an inflation and dollar crisis, not a gradual, very slow tightening back to a ‘normal’ range of 2-3.5% in the G2 (US and EU), which is to be expected. Whilst inflationary risks are out there, it will be a medium term problem unless the Fed does something completely stupid with virtually no tightening at all.
For the deflation scenario, we need only look at Japan. Japan is the best case study for three core issues now facing the US, and by default the world economy. Firstly, how they handled the banking crisis (or how not to handle one). Secondly, what happens when you end up with a generation of permanently damaged consumers, and by extension damaged private demand. Finally, the result of following a policy of continuous government demand stimulation, paid for by public debt. Could the US turn into Japan, with a permanent loss of output and a conservative, less active consumer? It’s a scary thought, but lies at the heart of assessing what form the recovery will take and how long.
I have to admit a bias, in that I worked in Japan for several years, have monitored their economy ever since, and been un-relentlessly critical and bearish. For the record, Japan remains one of my favourite countries-great culture, food and aesthetics-just lousy economics and demographics. My second bias results from working on the wreckage of the Indonesian banking system for six years after their crisis, and witnessing the level of damage to an economy a bank crisis leaves as legacy. I may therefore be over gloomy, but the lessons of Japan are still worth heeding.
Damaged Banks
I have covered this in the last Briefing, to which the reader should refer. In summary, financial crises are simply bad news. Normal recession recovery patterns don’t apply; a three to five year cycle to return to trend rate growth is standard; credit extension takes time to return to normal while both banks and consumers work through bad debts and deleverage; and impaired assets take a long time to clear. Again, as went Japan, there goes the US, minus the prop of 1990’s Japanese savings.
Rogoff and Reinhart, two Princeton academics, have analysed the past eighteen post war financial crises in a recent book (‘this time is different: Eight centuries of financial folly’). They come to the same conclusions I have summarized above. Rogoff and Reinhart suggest if the US conforms to type, it’s going to be a four year recovery with a long period of persistent unemployment, restrictive credit, and continued deleveraging by both households and businesses. That is my vote.
The US has also just repeated Japan’s mistake of leaving their banks with most of the toxic assets on their balance sheets rather than removing them into a state ‘bad bank’ and nationalizing banks if required–the Indonesian and Korean crisis model I strongly support. The UK also followed the latter model-Gordon Brown got it right. The half baked re-capitalization of the banks provided by the US is less effective, because the poison remains in the system. The Japanese did the same on the assumption that the banks could slowly grow their way out of the problem. Slow became the operative word-over a decade was required. There are no short cuts via assisted ‘self recovery’ for bank crises. The US missed the chance to take the pain, put them in an ICU, and temporarily nationalise. The availability of credit, and thus economic recovery, will suffer as a result.
Damaged Consumers
Japan’s lost decades: I don’t need to repeat the story of Japan’s so-called ‘lost decades’ following their own asset and investment bubble collapse in 1989. In essence, the economy was left permanently shrunken, with a huge level of overcapacity and dramatically reduced credit growth, investment, and consumption. Faced with the huge decline in private demand, the government resorted to endless rounds of stimulation, each one less effective than the last. The key issue is that consumers have never been able to pick themselves up again, so public stimulants had to replace private demand.
When Japan did recover, it found that it was a jobless and weak recovery. This is the risk the US faces. A quick summary of the data (Figure XIV) shows GDP growth has bumped around -0% to +2%, with bouts of deeper negatives for 20 years. The net growth is zero. Corporate profitability came back, but new job creation remained weak. As a result, wage growth in Japan has been negative, and unemployment climbed from nothing to Western levels of over 5% in a decade, where it remains. Land and house prices, the reference point for a consumer’s net worth, have never recovered. This leads to a strong negative ‘wealth effect’. Small wonder that consumer spend has been at a standstill, and the economy has been in and out of deflation ever since (it is currently back in deflation at -2.2%).
US employment: If there is one clear single signal that the US may repeat Japan’s pattern of long term damage to consumption, it’s the employment picture. The current official US unemployment rate, 10.2%, is dire. But this figure grossly underestimates the problem, because the official numbers exclude many inconvenient truths (those who have given up job seeking, part timers, new entrants to the workforce etc.). This total un-and under-employed figure for the US is approaching 18%. A ‘jobless recovery’, as looks likely, would permanently impair an entire segment of the population and thus their demand. And for those that doubt the potential of a jobless recovery, the US has already proven the case. The US has lost all the employment gains it made during the decade long boom. It employs fewer people today than in 1999.
The last number in Figure XV is of concern: 2.3 million additional new entrants to the job force. Assuming that rate continues, this means over 10 million extra jobs need to be created for the young over the next five years. The highest rates of unemployment in the US are the young: 15% for 20-25 year olds, and close to 28% for 16-19 year olds. Britain and Europe have the same issue, with 20% ‘youth’ unemployment.
A recent article raised the risk of a generation of young scarred by unemployment at the start of their careers, which leaves a permanent change in attitude and reduced earnings. Again, the case study was Japan. This group in Japan has ended up more risk averse than their peers, perfectly happy to work for the government, cautious on spending, and better savers. They stay at home longer with parents, lowering new household formation. This does not sound like the kind of high tech start-up entrepreneurs the US and the EU will require for the next wave of growth. Over the next three years at least 6 million young people will enter the US workforce, at the worst time since the great depression. Without policy intervention, they risk becoming a lost generation.
Finally, there is one difference to Japan, and it doesn’t help. The US has superior demographics. Faced with a jobless slow recovery, population growth becomes a disadvantage. The US population is now 300 million, having grown by 30 million since 1999. It is expected to continue to add 2.5 million people a year. The EU and Japan can get away with lower growth because their populations are static or shrinking, but the US needs its trend rate GDP growth of 3% plus to maintain real growth at a household level.
So unemployment will be the main drag for the US economy, 70% of which is consumption. There will be no real recovery until employment recovers. This means back to the 5% trend rate at least. Job creation has to be high enough to not only absorb the unemployed, but take on young new entrants and a growing population.
Damaged Public Finances and Debt
During 2009 all OECD countries have followed Japan’s post crisis policy set two decades ago-a major stimulus package, backed up by quantitative easing (printing money by another form), and very easy money (i.e. interest rates close to zero percent). Clearly the single biggest structural issue for the next twenty years will be the US government’s debt mountain, which now stands at 85% of GDP, and rising. This is the price of substituting public demand for private, a pattern repeated in the UK, and to a lesser extent in the rest of the EU. Remember the EU limit pre crisis was for national debt of 30% of GDP, a conservative but fiscally responsible figure.
As with Japan, the US cannot but be poorer as a result. The debt will consume much of the public’s earning power through taxes, and severely constrain public spending and other budgetary needs. This has to affect consumption, because consumers ultimately have to pay the debt back through taxes. As goes the US, so go Britain, most EU nations, and others with high national debts burdens.
Is it possible, as Japan has demonstrated, to have national debt climb to a very high level, yet maintain low interest rates. This enables low yields on that debt (i.e. low interest), and contains inflation. Japanese debt more than doubled from 60% to over 140% after a decade, and after 20 years has reached 219%. Yet yields in Japan collapsed and remain below 1% today.
It is questionable whether the US could repeat that feat, or if it is desirable to do so. Japan’s ultra low interest rates are part of the problem not the solution. Consumer activity suffered such lasting damage, Japan has been in and out of deflation ever since. Saving not spending is a good and necessary response for overstretched households for a few years, but if they never get back to the shops and simply save, the economy never grows again.
Japan’s ability to absorb all those government bonds (JGB’s) depended on a vast pool of domestic savings kept onshore. Most of these savings are turned over to the state via the largest deposit taking institution in the world-the Japan Post Office, which simply rolls it into JGB’s. Deposits in private banks go the same route. US households are rebuilding savings but will never get to the Japanese levels of the early nineties. And, we hope, they will go back to spending again at some point. That means that the US will have to go to the international debt markets, as will the UK and other big EU borrowers. This reliance of foreign buyers of debt will make it a lot harder for yields to stay this low forever, despite my leaning in the direction of a muted recovery and therefore low inflation pressure for the medium term. My deflation scenario is good for three years or so. After that, the world will return to worrying about inflation.
If the US is to avoid Japan’s fate with a permanently high national debt, higher taxes, and lower demand; or the alternative in a major inflation problem, it will have to pay down debt to a sustainable level. That means taxes or budget cuts, and likely both. A recent IMF paper on debt sustainability concludes that the US will have to increase taxes and reduce spending to the tune of 8% of GDP to get national debt back in the comfort zone of 60% of GDP, a huge hole to be filled in a 14 trillion dollar economy. It is no accident that this number is close to the level of cumulative lost output from the US economy, given that the loss has been plugged by the state using debt. But adding further to the tax burden is politically unpalatable. Given the Healthcare budget has gone up, that means the savings have to be found in the rest of the budget. The US simply won’t be able to afford what it used to. This will apply to all areas of public spending, including investment in infrastructure that the country needs, and in military expenditure and reach. Again, the same issues, and politically difficult budget cuts, will apply to the EU.
Conclusions
What are the lessons here? The US, and to a lesser extent the EU, still have some serious problems and need to continue repair-work. For the next three years minimum, I expect a pattern similar to that of post crisis Japan:
- Corporate profitability will return, but new job creation will remain weak.
- This means a jobless recovery, with a disenfranchised, unemployed underclass a permanent fixture, restraining wages.
- Several million baby boomer children will demand entry to the job market, but may struggle to get a solid start to work-life. This will add pressure on jobs and wages.
- A growing population will add even more pressure on jobs and wages.
- The public sector will take on a much bigger role to make up for reduced private demand and lack of private sector employment, Japan style.
- Wage growth will be restrained, so household balance sheets won’t grow.
- Higher taxes and reduced public services will make consumers feel poorer.
- Consumers will continue to deleverage and save, for at least another three years, perhaps permanently.
- Credit will not revert to normal for several years, as the banks remain weak and toxic assets remain on their balance sheets.
- A second wave of bank credit defaults will arise in the consumer loan books (especially credit cards) and commercial real estate.
- The decade long trend for decreasing taxes, direct or indirect, will reverse.
- Even if consumer price inflation remains benign, the return of energy inflation will function as an additional tax on the consumer.
- Overcapacity will suppress inflation for some time even as demand returns, as it did in Japan.
- This is the situation before policy risks. If the Fed responds to concerns about unsustainable asset price bubbles and tightens early, a double dip recession would ensue.
Those who doubt the parallels with Japan are kidding themselves. The US is already a shrinking economy in terms of its employment base and household wealth, but unlike Japan has a growing population to share this among.
It goes without saying that if this paper is correct, the risks are greater for deflationary pressures than inflation at this stage. When inflation re-emerges, it is likely to be benign. There is still a huge amount of overcapacity around the world, and that combined with limited or zero growth in average household income will restrain inflation. Oil remains, as ever, my only consumer price inflation concern. The inflation hawks are three years early. Asset prices will behave differently of course, and be driven by liquidity and speculative interest. They are likely to continue to rise, irrespective of economic fundamentals which argue for a major correction.
What about the argument that Asia will save the world? It is true that the GFC has accelerated the relative decline of the US. What was to have been a thirty year rise to global dominance by Asia will now be done in twenty. But in 2009 we all remain dependent on the health of the fourteen trillion dollar US economy, Asia more so than ever; and we will do so for some time yet. Asia remains export dependent, principally on the US and EU. As I have mentioned before, no one else is ready to replace the US consumer yet: the Europeans will not, the Japanese cannot, and the Chinese don’t know how yet.
For both the US and Asia, a slightly shrinking US has advantages. US households need to restore the health of their balance sheets by consuming less, paying down debt, and restoring a savings rate of at least 5-7%. Reduced demand from US consumers is the only way the Asian export driven economic model will be forced into accelerating self sustaining domestic demand. This requires building up the social safety nets Asian consumers require to persuade them to relax a little. Only then will they save less, and spend more.
Will this be a permanent ‘Japan lost decade’ for the US? Fortunately, I don’t think so. Rumours of the death of the US economic model and the dollar are greatly exaggerated. The austerity period will be longer and more painful than many imagine, which is what I have tried to convey in this paper. But the structural strengths of the US economy-its openness, dynamism, availability of finance, and above all innovation and entrepreneurial risk taking will ensure its resurgence after three to five years of serious and necessary repairs. The US has a remarkable ability to dig huge holes for itself, and then climb out again. They then repeat the process, on a seven to ten year cycle in my view, but that’s another story.
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