Don’t trust bulls who walked you and your money blindly into this maelstrom – we face years of subpar growth
DANTE ALIGHIERI, the celebrated 14th-century Florentine poet, describes an imaginary journey into the inferno known as hell in his most enduring work, Divine Comedy, and placed usurers or bankers in the seventh circle reserved for the violent. Given recent events in our own cosy financial community it's not difficult to understand why.
Solvency concerns continue to haunt the major banks but the opinions of our investment elite who have generated negative returns of almost 50 per cent since the summer of 2007 should also be considered bankrupt.
They remain undeterred. Those who saw no hint of a US economic recession 15 months ago, who argued forcefully that east Asia could withstand a western world slowdown and prescribed caution long after the damage to pension fund solvency had been done now tell us that we do not face a “lost decade” comparable to the Japanese experience of the 1990s. Will the comedy ever cease?
The facts speak for themselves and reveal that the US is already eight years into its own version of Japan’s “lost decade”. The economy has expanded at little more than 2 per cent per annum since the dawn of the new Millennium in 2001, cumulative growth in non-farm payroll employment over the same period is below 2 per cent and industrial production is on course for its first decade-long decline since the 1930s.
Furthermore, corporate profitability has collapsed and earnings-per-share are no higher today in real terms than 1989. Not surprisingly, share prices have dropped precipitously to the lowest level in real terms since the mid-1990s and 10-year returns are actually worse than the Great Depression. That sounds much like a “lost decade” to me.
The economic prognosis is not good but the perma-bulls maintain that the speed of action, with the reduction of short-term interest rates to the zero-bound, unprecedented fiscal stimulus and aggressive write-downs by the ailing banks, means that better days lie ahead.
Unfortunately, they are likely to prove wrong and the misunderstanding of elementary economic theory would be comical but for its impact on client returns.
It is important to appreciate that this is no ordinary recession and, unlike the Japanese experience, is truly global. There will be no vibrant export sector to cushion the blow.
It is centred on overstretched balance sheets not only in the financial sector but also among households who were led to believe that rising asset prices negated the need for income-based saving and sensible balance sheet management.
Conventional monetary policy is likely to prove impotent in the face of the long-overdue deleveraging or, as the economist John Maynard Keynes pointed out, it’s like pushing on a string.
America’s financial sector enjoyed an unprecedented period of prosperity through the 1990s and beyond that, which was accompanied by a six-fold increase in outstanding debt that amounts to almost 120 per cent of GDP today.
The good times are clearly over and severe asset price deflation and mounting losses means that the sector is now insolvent and in no position to begin a normal lending cycle so typical of economic recovery.
Cumulative losses on US-originated assets are now forecast to reach $2.5 trillion as against initial perma-bull estimates of just $100 billion. Though half of the total will land on foreign institutions, weakness overseas means that the hit to US banks will still fall in the same ballpark. The sector needs to be re-invigorated before an economic recovery can be assured but, so far, all efforts to address the problem have fallen short.
The walking dead need to be slain and the strong recapitalised immediately if the US is to stand any chance of not repeating the Japanese experience.
A healthy financial sector is necessary but not sufficient to produce a self-sustaining recovery. America’s Ponzi economy saw household savings rates drop from roughly 7 per cent in the early 1990s to below 1 per cent as recently as last spring. Outstanding debt as a share of GDP jumped from 62 per cent to more than 100 per cent with most of the increase arising in recent years.
Massive wealth destruction combined with heavy job losses means that America’s beleaguered consumer has little option but to deleverage. Given that consumer spending amounts to 70 per cent of GDP, balance sheet rightsizing will subdue economic growth for an extended period.
President Obama has not surprisingly resorted to aggressive fiscal stimulus to reduce the economic damage but the near-$800 billion package is not nearly enough to offset private sector contraction even using the most optimistic of assumptions. Indeed, even the analysis provided by Christina Romer and Jared Bernstein from Team Obama does not foresee a drop in the unemployment rate below 6 per cent or almost one percentage point above full employment until 2012. The bottom line is that cumulatively output could easily fall $4 trillion short of potential.
The US and the western world therefore face a prolonged period of subpar growth but not according to the perma-bulls who walked you and your money blindly into the current maelstrom. The analysis is shoddy and fails to recognise that a “lost decade” is already in progress.
A modern-day Dante would surely consign such commentators to the seventh circle of hell.
