By Thomas J. Connelly, CFA, CFP
A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury , with the result that every democracy will finally collapse over loose fiscal policy, (which is) always followed by a dictatorship.”
–From The Fall of the Athenian Republic, by Alexander Tyler, 1787
By now it is evident, even to the media that the developed economies of the world are struggling to recover from a global depression rather than typical post-war recessionary conditions.
A typical recession starts after business and credit activity increase to the point where inflationary pressures and interest rates rise. The latter may result from market forces or central banking authorities raising rates to forestall inflationary pressures. Once the slowdown hits, central bankers ease liquidity conditions and lower interest rates to encourage credit expansion and reinvigorate the economy. Governments play their part as well by running budget deficits to augment consumer income and business investment.
This formula for recessionary cure went awry beginning in the 1960s when hard financing decisions between wars, goodies for the citizens, and fiscal responsibility were not met head on. From the Vietnamese conflict, through the two Iraq wars and Afghanistan, the US chose debt as a financing option rather than higher taxes or cutting other spending. Defense is not the only bad guy here. Ditto for entitlement and other government programs, which expanded in scope and magnitude far beyond what the originators of the legislation envisioned.
Along with the growth of government debt, our consumer society was grown with tax incentives for taking on debt, rising real estate and equity markets to borrow against, and readily available consumer loans. Consumer debt grew faster than the economy through the 1980s, 1990s, and took off on a whole new trajectory of growth in the 2000s as consumers were allowed to borrow against the exploding values of their homes with little concern about ability to service debt if housing prices stopped growing.
Total resulting consumer, corporate, and government debt burdens expressed as a percentage of GDP are shown below.
The problem of growing consumer, corporate and government debt burdens is not isolated to the US; it is a global problem, to a much greater degree than was the case in the Great Depression. This is one important negative difference between the Great Depression and the Great Recession. The deflationary undertow is arguably greater this time around.
The US burden is currently around 279%. Japan’s burden is in excess of 500%. Many of you may be surprised to hear that the Canada’s debt load is as high as ours at 276%. None of these numbers include future government obligations for retirement income or health care costs.
In theory, the debt incurred by running fiscal deficits to get us out of the bad times should be repaid during the good times. Interest rates should not be kept artificially low for extended periods into recoveries. Yet both of these maxims were violated repeatedly, with the exception of Paul Volcker’s tenure as Fed chief in the early 1980s, which has led to an expansion of consumer debt and government debt that is the true cause of the developed world’s problems today.
Encouraging an economic environment built around consumer and government spending financed by debt has led us to our current predicament: depressionary conditions where debt burdens are the ultimate source of the problem. We simply have spent too much of our future income to enjoy today, and imposed that burden on our children, grandchildren and so on without their permission or vote.
Not only do the high levels of indebtedness suggest that we are in a different type of downturn, but employment numbers tell a similar story.
Job losses during the latest downturn far exceeded those of any post-war recession, and have recovered much slower as well. The pace of job recovery is substantially behind the pace of previous business cycle recoveries as well. Other economic metrics, such as industrial production, corporate sales, and capacity utilization tell a similar tale. The downturn of 2007-09 is truly different in character, scale, and magnitude from any other post war downturn.
Ray Dalio at Bridgewater has termed the recovery process from a debt depression as a deleveraging process. These can be orderly, serving only to reduce economic growth and minimally reduce the standard of living while the debt burden is reduced over a period of years, or they can be chaotic, as ours was in 2008, where confidence is shattered and economic activity freezes because no one is sure who is solvent and who is not There are four basic knobs to turn in the process: debt reduction ( occurring everywhere in the US except for the government), austerity (happening in Europe but certainly not here or Japan), transferring wealth from the haves to the have-nots ( Europe has already done this; we are just in the beginning stages), and debt monetization.
Too much austerity too soon send an economy into a downward spiral of crashing economic activity and incomes along with a rising debt burden. Think the US in 2008 and Argentina in the early 2000s. We have voided this problem for now, but Europe is conducting a grand experiment with austerity. Since government consumes 40-50% of European output, they have little room to maneuver. Likewise, excessive money printing can lead to high inflation down the road. Currently, there is much slack in labor and industrial capacity, and very little credit growth, which constrains inflation expectations from forming. But an economic recovery could change all of that within the span of a few years.
Our theme of fire and ice in our 2008 missives, referring to the elevated possibility of extreme deflationary or inflationary outcomes still holds, and investors must keep hedges in place against these possibilities. But fire and ice is far from the only possible outcome. A balance of austerity, taxation, restructuring debts, and monetization through time can lead to an orderly deleveraging over a period of 3-10 years in the US without financial or social upheaval. Bridgewater believes that current US policy gives us a good chance of accomplishing an orderly deleveraging, which is an encouraging thought. The European and Japanese central banks have just begun to monetize some of their debt. Peripheral Europe may not have any more options. Unemployment in Spain and Greece exceeds 20%, and Greece’s GDP is down 15% over the past three years and falling. We must be careful: these are the types of environments where Lenin, Mussolini. and Hitler ascended to power. We simply cannot ignore the social ramifications of the implementing economic policy.
We mentioned that the magnitude and global extent of debt in the industrialized world is higher now than in the Great Depression. We must also remember that policies that helped individual countries emerge from economic crises in the past cannot work on a global scale. In other words, all countries cannot all devalue their currency at the same time, although the price of gold suggests they are trying mightily. Not every country can run a trade surplus, it is mathematically impossible, and not every country can implement austerity at the same time – the result would be a global depression that we may not emerge from for decades.
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