In the understanding of what lies ahead for the economy and financial markets, many viewers and regrettably government policymakers fall back on their lifetime experience to make sense of the underlying forces and patterns of the economy and financial markets. Hence, heavy reliance has been placed or misplaced on the template of the usual Post WW II business cycle of recession and recovery as the model for the current economic malaise. However, the recession has been experienced, the policy cure has been applied but the recovery has not been forthcoming. At this point three years into the current recessionary episode market observers are beginning to wonder if the malaise gripping the economy is unrelated to the template being used to explain and treat it.
Their suspicions are correct. The underlying forces that are moving economies and financial prices today are not those of the usual or even a severe post-WWII business cycle with the usual remedies, responses and time lines. It is as if the recession was diagnosed as a bad cold and is being treated with double the usual cold medicine with greater allowance for recovery time. However the current economic malaise is a different disease requiring a different remedial approach and doubling the typical cold medicine has nasty side effects when applied in the current circumstances.
What is afflicting the economy is a relatively rare but not unprecedented “debt deflation” as described by Irving Fisher some 77 years ago (The Debt-Deflation Theory of Great Depressions). As I am sure most readers will anticipate a debt deflation separates recessions from Great Depressions as we have experienced in the 1930s and other times in the 19th century such as the l873 bank panic episode followed by years of deflation.
What is at the core of this malaise is an accumulation of debt relative to income that fueled the preceding economic booms and when the debt relative to income rises, the servicing of the debt, both principal and interest deflects a larger share of current income from spending on goods and services. This is true whether the consumer is serviced its own debt or is called upon to pay higher taxes in order to service government debt. This I shall term debt satiation.
Debt satiation was not present during the previous post WWII garden variety recessions when debt loads were not the stumbling block to renew debt financed spending and economic recovery. Indeed the effort to contain recessions into being recessions and not depressions was the systemic increase in debt financed spending either by the government (called fiscal policy) or by consumers and businesses promoted by monetary stimulus when the Fed supplied banks with cash reserves that would faithfully be loaned out and dutifully spent by consumers and businesses.
What was common to the recessions and their remedial actions was the capacity to add more debt without de-habilitating the capacity to spend. Economic recovery by debt financed spending would work as long as the added debt to income ratios did not increase debt service (principal and interest) as a percent of income or taxes as a percent of income in order to service Federal debt. What allows that to occur is the availability of cheap financing sources in recessions so that marginal debt accumulation whether government or private takes place at lowers interest rates. The lower interest rates provide cheap marginal new debt and also provide general debt service relief when pre-existing debt is refinanced at lower rates.Why this time is different and why this 2007-2010 economic decline is not the garden variety post WWII recession is because debt has been accumulated to the point where the US debt to income ratios have risen quite dramatically as shown in the accompanying Figure especially since the l980s. This is not an absolute accumulation of debt but an accumulation of total debt including government debt RELATIVE to income. Hence our starting debt service load when this recession began was quite high and since we are at the lower bound of policy interest rates (zero) and banks charge substantial risk premiums, debt service relief is not occurring for bank dependent borrowers. Hence the usual post WWII recessionary medicine of adding debt financed spending is not working though our policymakers well trained in this remedial method keep trying and trying to stimulate economic growth by adding yet more debt financed spending.
To state this in the more usual policy terms, the GDP multiplier kick from a Dollar of additional government spending is now less than 1 which means we add more debt than income which further increases the debt to income ratio. Hence fiscal policy adds to debt satiation. (See: Economic Policy Has Reached a Dead End and The Recession Continues) As for monetary policy, The Fed is unable to coax banks to lend and consumer to borrower and convert bank lending into spending. In fact, the money supply multiplier is negative as private bank lending has contracted despite a massive increase in the monetary base. At least monetary policy is not contributing to debt satiation but it’s ineffective in promoting economic growth.
As we commence the fourth year of this economic/financial malaise, the consumer is in deleveraging mode and offsets government efforts to jump start spending and income generation. The consumer has been successful in net reducing debt at the rate of about $250 Billion/year but the sluggish economy provokes more calls for government spending. In 2009 the net result was to add to over-all debt satiation as the Federal government debt grew by $1.4 Trillion in an attempt to offset the ill effects of the $250 Billion consumer debt retrenchment. How long does the consumer have to go to reduce debt to more accustomed levels? At this rate of consumer debt contraction it would be another decade just to relieve its balance sheet of the 2003-2007 expansion in debt and during this time government debt is scheduled to increase by roughly $10 Trillions to cover the usual structural deficit and future unfunded pension obligations let alone new stimulus. Ironically, the dynamic in place of the consumer attempting to reduce its debt load adds to overall debt satiation. This is a qualified conclusion however. Debt satiation will occur only so long as the government can continue to successfully finance its deficits.
This is now where the “rubber meet the road.” That is, can the government continue to have traction to finance its debt accumulation or will we ultimately meet the same fate as Greece? Faced with this market constraint of the ability to expand the debt satiation economy, at the recent G-20 meetings all countries but the US committed to running more containable fiscal deficits in an effort to reduce debt satiation. That is, governments turned collectively from expansionary monetary and fiscal policies to a policy of containing indebtedness. As this contemplates less spending and more taxes it is also known as “austerity.”