A Delusional Belief in Debt-Based Growth
Last week, the bull market continued. Investors were sure that the bailout of Europe’s wobbly debtors was a done deal. The details of the deal have yet to be worked out. Just details, of course…such as who’s going to pay for it and where they’re going to get the money.
That, and whether Europe’s 17 nations will go along with it…when they finally figure out what “it” is.
For now, nobody knows.
Here’s how we look at it. After WWII, Europe rose from its ashes while America went from strength to strength. The entire developed, non-communist world — including Japan — enjoyed its “30 glorious years” of growth.
Then, something went wrong. The zombies gained power…and gradually shifted more and more resources to unproductive sectors. At the same time, the payoff from increased use of fossil fuels (the real cause of above-trend growth since the advent of the Industrial Revolution) reached the point of declining marginal utility. Energy prices rose and it was more and more difficult to find applications that would pay off.
Together, these phenomena caused real growth rates to decline. Neither in France nor in America have real wages shown significant improvement since. That is, for the last 40 years, the earnings of the typical working stiff have barely improved.
How to react to this challenge?
In the US, households ran down their balance sheets. They made up for the lack of income growth with debt growth. This allowed them to continue improving their standards of living until the 21st century.
In Europe, it was governments who ran down their balance sheets. They made up for the lack of income growth with increased public services, financed by debt. This allowed people to improve their standards of living even though they weren’t earning more money.
In terms of total debt, there is not much difference between the countries of Europe and the US. All have total debt-to-GDP ratios in the 250%-300% range. Some a bit more. Some a bit less. In Europe and Japan, the debt is concentrated in the public sector. In America, it is mostly in the private sector…with the public sector gaining ground fast.
Of course, the people who sell debt — namely, Wall Street, the City in London, and the rest of the financial industry — did wonderfully well. In America, for example, the percentage of total corporate profits coming from the financial industry rose 300% during the last three decades.
That is why people think the banks were the cause of the problem. Mostly, they were just in the right time at the right place to benefit from a trend that they didn’t cause and couldn’t possibly control.
Then, in 2007, the reckoning began. All of a sudden, the private sector in the US buckled under the weight of so much debt. People couldn’t pay their mortgages…and then the geniuses at the finance companies realized that they were broke. Their sliced and diced mortgage debt was not nearly as solid as they had thought.
Governments rushed to bail out the banks, who just happened to be large campaign contributors. The feds swamped themselves in the process. Iceland and Ireland were the first to sink. Then, all the periphery of Europe was shipping water.
Back in America, whole towns were soon underwater…such as Las Vegas and Orlando. In Europe, whole countries were submerged, such as Greece.
And what did the authorities do? What was their solution?
Alas, they are all one-trick ponies. And the only trick they know — adding more debt — doesn’t work. But they keep at it…lowering interest rates, offering more credit on EZ terms to everyone. Students are encouraged to shackle themselves to a lifetime of ball-and-chain education debt. Homeowners, who should swim away from their underwater houses, are encouraged to refinance. Everyone is encouraged to spend money he doesn’t have on products he doesn’t need so that the economy will go where it shouldn’t go — further into debt!
But even if the feds can get households to repeat their errors…they won’t be able to keep it up; they’re running out of money. A Wall Street Journal blog explains:
Like the Cardinals’ David Freese, the US consumer stepped up to the plate and hit one out of the park in the third quarter. Unless job and income gains pick up, though, the household sector may not get past first base this quarter.
Consumer spending powered the 2.5% annualized gain in real gross domestic product last quarter. The monthly numbers show spending ended the quarter on a very strong note in September, despite surveys showing the household sector very downbeat about the economy.
Can consumers keep buying in the fourth quarter?
There are, however, a few reasons for caution. Income gains are trailing spending increases. Personal income edged up just 0.1% in September. After taking price changes and taxes into account, real disposable income has fallen for three consecutive months.
As a result, last quarter’s spending gain came at the expense of savings. The September saving rate dipped to 3.6%, the lowest rate since the recession began in December 2007.
Consumers cannot ignore their nest eggs indefinitely. Households need to pay down existing debts (a form of saving) and to replenish retirement funds eroded during the financial crisis. A saving rate closer to 5% is needed to repair household finances.
Looking beyond the fourth quarter, much faster hiring and wage growth are needed to solidify the consumer outlook.
Good luck on that!
Debt has become an impediment to growth, not a facilitator. Like energy, it reached the point of declining marginal utility years ago. The feds can still add debt — at least in America — but it won’t make the economy grow. Instead, it crushes it.
And when investors finally figure this out they will sell their stocks…and the markets will be free to complete their rendezvous with the bottom.