|Tuesday, January 06, 2004
Thinking about the next slowdown
There I go again, thinking ahead.
We survived 2003 thanks to the continuation and expansion of the greatest
credit bubble in history. By the end of 2003, the ratio of debt to GDP
should be 3.1 to 1. In 1982, it was 1.7 to 1. In 1990, it was 2.3 to 1. In
the last four quarters, we've added $5 of debt for every $1 of GDP. The new
Z-1 tables will be out on January 8th, and I don't anticipate they will be
Japan, China and the rest of East Asia are lending us about $1 trillion a
year just to keep our currency from depreciating too quickly. Private
investors bailed out last year, so the central banks had to step in. It
hasn't helped much. The Euro is up to a record high of $1.27 today. The Yen
is up to 106 to the dollar. If China were to revalue the Yuan, we would see
a very quick uptick in inflation. We're already seeing a jump in raw
materials prices because the Chinese are starting to buy them instead of
our debt securities. Either we get inflation, companies sacrifice profits,
or we borrow even more, inflating our debt instead of our CPI.
And at some point, there will be limits to how much we can borrow. The
ratio of debt to income will eventually backtrack to more sustainable
levels, someday. Foreign central banks are clearly nervous, and there are
scattered voices among economic commentators that maybe, this time, the
dollar reserve monetary system may be ending once and for all. China is
considering repegging the Yuan to a basket of currencies, for one.
If there is such an adjustment, there are two ways that debt to income
levels can return to normal. The first is a debt-deflation that reduces
debt levels through default. This will also crush asset prices. We should
hope we don't go that way. A more likely candidate is a resurgence of
inflation, which boosts nominal GDP relative to debt levels. The Federal
Reserve is certainly hoping for the latter outcome. The only difficulty is
that if official inflation picks up, then there will be upward pressure on
interest rates as well. In an economy living and dying by monthly payments
and refinancing, and growing numbers of people converting to
adjustable-rate mortgages, a rising interest rate environment contains its
own corrective mechanism. If we can no longer reduce monthly payments (or
if they increase), we can no longer spend and the economy slows down again.
And we used a big chunk of the leeway we had just to get through the year.
Thanks to the tax cut, the federal budget deficit is expected to be around
$500 billion or almost 5% of GDP. The Federal Funds rate remains at a
50-year low at 1%. Thanks to the largesse of our foreign creditors and
money market funds yielding nothing, we were able to fund any bond issue
that dollar borrowers needed to float, particularly if it was corporate and
high yielding, and yield spreads fell to levels not seen since the bubble
years. Everything went right, and there is little room for improvement. If
the economy were to slow down, there simply aren't a lot of resources left.
During periods of economic growth, we should see a gradual reduction in
borrowing, particularly by the government. We should see a resurgence of
employment - 300,000 jobs a month, not 100,000. We should see the Fed
boosting interest rates, not keeping them at obnoxiously low levels. That
we are not seeing this taking place belies the daily blathering of a
strong, recovering economy. Things are not right at all. Current policy is
contradicting decades of economic thinking. NAIRU and Taylor's rule are out
the window. Doesn't that seem odd?
So what happens as the economy gradually slows down? Economists certainly
don't believe we can keep 8% up forever. Paul Kasriel is predicting a 3.7%
growth rate for the fourth quarter. After that, what if we don't get 4% GDP
growth as far as the eye can see? Will employers want to hire? Will the
government be able to engineer another tax cut? Will the Fed lower interest
rates, and will anyone care? Will states be able to stay solvent? Will
housing prices go up another 10%? Will the falling dollar finally increase
CPI inflation, or will we just be able to inflate our asset prices and debt
levels for another year?
Things certainly look shaky at present. We've been seeing one good piece of
economic news followed by one bad piece. Again, not the stuff that
sustainable recoveries are made of. I think the most likely scenario is
that a slowdown in the U.S. will impact other nations first. South Korea
has a significant consumer credit bubble. Mexico would be immediately
impacted by a decline in U.S. imports. Japan and Europe are already
tottering on the edge of recession. At that point, they will have to decide
whether to keep financing our borrowing binge or start redlining us. The
next six months are going to be key to whether Bush gets re-elected. If
things start to slow down abruptly, he is going to be toast.
posted by Teddy