The Debt Cycle

A while ago, I read a comment on another website about this blog. The commentator was very positive about my analysis, but also pointed out that I was not so good on market timing. I thought that this was a very fair comment. The reason for this weakness is that I struggle with how the individuals in the market get so much so very wrong.

I thought of this today, as I saw the news on the latest falls in stock markets. The reason for the falls are the potential problems in Hungary, with yet more sovereign debt woes, and poor US unemployment data. In the case of the unemployment data, the really bad news is that much of the increase in employment is down to the mass hiring for the short term to conduct the US census. In fact, nearly all of the new jobs created were a result of the census. The really worrying aspect of this is that this abysmal performance is that it is taking place in the context of such massive government borrowing.

I have copied the chart of US federal surplus or deficit from the St. Louis Federal Reserve. It was not so long ago that such charts were seen as regular feature of economic commentary, but they seem to have fallen out of fashion. Sometimes, it seems that it might be a good idea to remind everyone of exactly how much money is really being poured into the US economy through borrowing.



This from the Wall Street Journal:

THE US deficit has reached $US13 trillion for the first time in history, the Treasury Department said yesterday.

Amid vast Government spending designed to stave-off economic calamity, the debt reached $US 13,050,826,460,886.97 on June 1.

The debt has increased by around $US 1.6 trillion in the last year and more than doubled in the last 10 years.

It now stands at just under 90 per cent of annual gross domestic product.

Below, we have the US current account. It is not a pretty sight.



In other words, the US government is borrowing mountains of money that is barely denting unemployment, and the money is helping to support ongoing over-consumption. What can be good about such a situation?

The supporters of deficit spending would argue that, without the massive deficits, the unemployment situation would be far worse. I am actually in agreement with this, and what the level of unemployment might be without deficit spending would otherwise be does not bear thinking about. However, these levels of deficit and the over-consumption can not be sustained. The cost of such massive borrowing is to just push the unemployment into the future, and that is really no solution.

I am highlighting these underlying problems for a very simple reason. As the Euro crisis accelerated, the US became (once again) the 'safe haven' destination for investors. How can we explain such a perspective? Below is a chart of US GDP, which goes some way to explain why there is a false confidence in the US economy.



If we compare the chart for the accumulation of debt and the GDP chart, the source of this 'growth' is obvious, but that does not seem to have deterred investors. The US is only 'safe' if the US government keeps on borrowing and if it stops borrowing at these levels it will very quickly become 'unsafe'. The problem is that, as fast as the US government borrows to spend the situation of the economy is still deteriorating. As the unemployment figures are showing, there is no real recovery, and the lack of a recovery is coming at a monumental cost.

$US 1.6 trillion is buying no real jobs growth. It is just preventing a massive jobs slide.

The real question that needs to be asked is where the real growth in jobs might come from. When thinking of the horrendous underlying unemployment (i.e. the level without the borrowing), it is apparent that there needs to be a huge surge in employment in many sectors of the economy. This looks to be highly improbable. What we are looking for here is not jobs growth, but a jobs miracle.

Then there is the context in which such a miracle must take place. Europe is about on the edge of commencing considerable fiscal retrenchment. With such retrenchment, the export market for US goods is about to shrink, with Europe accounting for over one tenth of US exports. Then there is the ongoing strengthening of the $US against the Euro, which will disadvantage US exporters in an already declining market. The rush of money into the 'safety' of the $US has the perverse effect of making the $US less safe by strengthening the dollar. It is the curious situation where the more a currency strengthens, the more it will build weakness in the long term. Imports will rise, and exports will fall. In this case, it is not a strengthening on the basis of underlying economic performance, but just a panicked movement of money.

This is a quote from Geithner, from a recent letter sent to the G20:

"Given the broader shifts under way in the U.S. economy towards higher domestic savings, without further progress on rebalancing global demand, global growth rates will fall short of potential," Mr. Geithner wrote, according to a copy of the letter viewed by The Wall Street Journal. "In this context, we are concerned by the projected weakness in domestic demand in Europe and Japan."

From the same article as the quote, The Wall Street Times says the following:

"The necessary shift toward higher savings in the United States needs to be complemented by stronger domestic demand growth in Japan and in the European surplus countries, and sustained growth in private demand, together with a more flexible exchange rate policy, in China," Mr. Geithner wrote.

U.S. Treasury secretaries have been delivering that message in various forms for more than a dozen years, pleading with Europe, China and emerging Asia to adopt policies that encourage their own consumers to boost purchases of U.S. goods and services while vaguely promising to shift American economic patterns toward savings.

How this magic transformation might take place is the big question. Europe will not pick up the slack, and China can only continue to allow its economy to grow bubbles for so long. Emerging Asia might have potential, but it is not clear why the US would win from such growth, in particular as long as the safe haven effect continues to hold up the value of the $US. The other problem is that, with a weakened Euro and £GB, Europe will see competitive strengthening in relation to the US in all export markets. As I have said, the movement of money into a 'safe haven' undermines itself.

What this suggests is that there will be no chance of export led growth as long as the $US remains a safe haven. The greater the borrowing of the US, the greater the demand for the $US to put into 'safe haven' lending, and the greater the demand for the $US, the more the value of the currency is subjected to upward pressure, and the more entrenched the problem of export led growth becomes. It is a circular process, and all the while in the background, the debt in the US continues to mount, and unemployment persists even as the borrowed money pours into the economy.

As the situation stands, there is no probability of a jobs miracle in the US that might come from export led growth. As long as the US remains a safe haven, the effect will be the opposite with import led job destruction. This in turn leads to the problem that, the more jobs that are destroyed, the greater will be the reliance on borrowing to support employment in the US, and this in turn provides the instruments to meet 'safe haven' demand for $US.

What you can see is a process in which the US economy becomes increasingly structured around debt. The more the US government borrows (as long as demand continues), the greater the job destruction in the US from increasing imports and falling exports, and the more the government must borrow to maintain unemployment, and the more the economy becomes structured around the borrowed money, the more entrenched the problem of stopping borrowing becomes........and so on, and on, and on.....

Within all of this, there is the question of where the demand for the $US would come from, were it not from buying $US to lend to the US government. The US is still a huge exporter, but nevertheless has a current account deficit. In addition, the $US is the reserve currency and the currency of trade, and there is therefore demand for the $US for transacting trade. World trade has been increasing of late, which might be a driver for demand for the $US, but that increase commences from a low point. There is also demand for $US to buy assets, such as stocks, but the greater the demand for this kind of investment, the greater the chance of asset bubbles, and the greater the perceived risk for investors.

In other words, without the government borrowing to soak up demand for 'safe haven' currency, it is unlikely that the $US would be able to hold the current valuation. In other words, it government borrowing that is entrenching and expanding the problems in the US economy. By borrowing so much, the US is both accumulating unsustainable debt, but is also providing an asset that meets the demand for 'safe haven' $US. That safe haven status is just a spur to further destruction of the US economy, as it points the US economy into a downward spiral of debt dependency. It destroys sustainable jobs, even whilst it creates (eventually) unsustainable debt supported jobs.

In a world in which many countries are seeking to export their way out of trouble, being a safe haven is not a solution, but is actually a medium/long term problem. The answer is, of course, to break the cycle, but nobody dares to do so. In breaking the cycle, the underlying problems will rapidly emerge, and the economy will tank. As such, the cycle continues, and the problem of an economy being shaped by debt dependency just grows ever more acute. It can only mean greater destruction in the future, as the underlying economy must eventually move from debt dependent employment to sustainable employment. And that means a period of massive unemployment.

Note:

I hope that the post makes sense. I have re-read it a couple of times before finally deciding to post. I have a niggling doubt that I have missed something out. Please feel free to point out where you might think that I may have missed something.