Economic recessions can be divided into two types: mild or standard downturns which tend to be relatively brief and shallow, and severe or non-standard downturns that tend to be both long and deep. The recent recession was definitely a more severe type, but it was kept relatively brief only by the unprecedented scale of government and central bank intervention.
A useful way to differentiate between the two types of recession was devised originally by the American economist Irving Fisher in 1933. He argued that the reason for the severity of these downturns was due to a prior build up of debt and that when credit bubbles burst they created havoc with household, corporate and financial sector balance sheets, leading to bankruptcy, negative equity and lengthy debt work-outs.
Two overlapping bell curves
The emergence of a credit bubble and its aftermath, or the process of “bubble and burst,” may be visualised as two overlapping bell curves, where each curve measures leverage or the ratio of debt to income. The first bell curve represents the leveraging up of the private sector as it increases its ratio of debt to income (or GDP) during the bubble phase, followed by the de-leveraging phase. The second bell curve represents the ratio of government debt to GDP which also follows the same pattern, though it does not necessarily reach the same levels.
When a bubble bursts, the private sector typically de-leverages rapidly, reducing spending and repaying debt. However, the onset of recession causes government revenues to decline abruptly, triggering a government budget deficit and an increase in the ratio of government debt to GDP. In addition, as the recession intensifies the government may commit to additional fiscal stimulus measures, further expanding the public sector’s deficits and debt ratio. This explains why – in a modern economy – the government’s debt ratio typically starts to rise steeply at exactly the moment when the private sector begins to de-leverage. Since this process of government rescue and stabilisation in the aftermath of banking crises has occurred many times in many countries, there are numerous case studies which show how the debt problems have been resolved. A study by the management consultants, McKinsey, classifies the ways out of such crises into four major archetypes: high inflation, government default, growing out of debt and belt-tightening. However, since their analysis is not complete, there is one more possible outcome: the debt trap.
Five exit strategy options
The first “solution” to the balance sheet or debt problem is to generate high inflation
(Figure 2), because this rapidly erodes the real value of the debt while raising
the nominal value of assets, enabling the private sector to de-leverage more easily. However, assuming it is easily possible to create high inflation the process has very damaging effects on real economic activity and on income distribution since debtors and wealthy holders of property and equities benefit while creditors and small savers suffer. Under high and rising inflation both private and public sector borrowing typically decline sharply in real terms since few people are willing to lend under these conditions. Consequently the real volume of lending under high inflation typically contracts.
A second strategy to escape the over-leveraging problem is public sector default or debt re-structuring, especially if the bursting of the bubble is accompanied by a banking crisis or currency crisis since a large devaluation makes foreign-denominated debt a much greater burden to repay. Rating agencies will normally downgrade the debt of a government with excessively large debts or with weak growth and revenue prospects - as they have done recently with Greece and Spain. Default inevitably means that the economy loses access to the credit markets for several years subsequently. In this sense default serves as a mechanism for imposing the discipline of de-leveraging on excessive borrowers and spenders – public or private.
The third option is “growing out of debt.” This means that it is the growth in the GDP (the denominator of the debt-to-GDP ratio) that gradually brings down the overall ratio rather than any deliberate de-leveraging or reduction of debt (the numerator). Episodes of this kind are comparatively rare because there are few instances where the GDP has the capacity or opportunity to enjoy a growth spurt. Typically these episodes occur either as a result of a commodity-induced boom or as a result of the outbreak of war.
The fourth possibility is the debt trap, a situation illustrated by Japan’s experience in the past two decades. After the bubble of 1985-90 burst, GDP growth in Japan slowed unexpectedly for a prolonged period of time and resulted in a progressive deterioration of the government’s budgetary position. The public sector debt to GDP ratio started to rise in the same way as in the bell curve of Figure 1 but the government’s fiscal and monetary policies have failed to revive the economy. The result is that Japan’s public debt to GDP ratio simply kept on rising, even after the private sector debt ratio had stabilised. The ratio of Japan’s gross government liabilities to GDP has now exceeded 180%, and the OECD forecasts a ratio of 204% in 2011. Consequently Japan’s overall debt is growing faster than the rate of growth of nominal GDP, meaning Japan is essentially in a debt trap. The only reason this is sustainable is that the interest rates on government debt are so low.
The fifth and final option is the belt-tightening solution. This refers to a collection of economic policies where public and private sector debt together grow more slowly than the nominal GDP over many years. (The nominal stock of debt may even decline in absolute terms, but this is not necessary.) In practice this “solution” is the most common in recent decades, especially among developed economies, and is the one being mapped out by Britain, the US and other European economies in the wake of the recent crisis.
The empirical evidence from many countries that have, over recent decades, experienced balance sheet recessions and sovereign debt crises suggests the solution to the debt problems of developed economies including the Euro-zone will not come in the form of high inflation or a miraculous escape through a growth spurt, and governments will strive hard to avoid either default (or restructuring) or a Japan-style debt trap. That leaves belt-tightening as the only remaining and most likely option, although realistically it takes years for governments to reduce indebtedness even if their economies can resume growth promptly.
Some of the contrasting shades to this debate became visible in the June 2010 G-20 summit of developed nations held in Toronto, with cracks appearing in the consensus favouring bigger deficits to spur job creation, the reaction to the economic crisis that began in 2008. Different approaches emerged at the summit towards balancing the need to promote greater economic growth and job creation in the short term with fiscal discipline and the long-term desire to reduce national debts. In particular, US President Barack Obama argued at the Toronto summit for developed nations to continue stimulus measures to prevent another global economic downturn.
Shaky Recovery
In the aftermath of the global financial crisis in 2008, the US, along with other economies, suffered a negative demand shock, with a decrease in demand for goods or services. Pump priming by governments may have averted disaster but could now be fostering financial speculation rather than providing the solid groundwork for recovery. The potential inflationary consequences of government stimulus and mixed economic data releases continue to fire up the advocates of the respective camps in the inflation versus deflation debate.
With an immediate term outlook already clouded by uncertainty created by Europe’s debt problems, strained government finances pose a major threat to global recovery, according to the International Monetary Fund (IMF). Even so, the IMF has raised its forecast for global economic growth for 2010 to 4.5% from 4.0%.
The recovery’s fragility periodically gives rises to fears about a slowdown, particularly in China, the economy of which has functioned as a global growth engine. Such fears were recently amplified by a drop in the Chinese Purchasing Managers’ Index (PMI), an indicator of the health of the manufacturing sector. On a positive note, May’s durable goods numbers in the US had encouraging elements.
The resilience of the recovery is finely balanced. Particularly in the West, reducing debt or ‘deleveraging’ – a process to be undertaken over many years – is likely to constrain growth.
For the moment, inflation in the US can be judged to be fairly moderate – core inflation, which excludes energy and food products, is on a downward trend. There are also downward pressures in the Eurozone. Annual inflation in the Eurozone is expected to be 1.4% in June, compared with 1.6% in May, according to a flash estimate issued by Eurostat, the European Union’s statistical office. In the UK, even with the Consumer Prices Index (CPI) well above the government set 2% target, the Bank of England has kept UK interest rates on hold at a record low of 0.5%.
The spectre of deflation
The Great Depression of the 1930s is very much imprinted on the American psyche. Fears of a re-run may have receded due, in great part, to the significant stimulus provided by the government but have not been completely dispelled. Historically, the US has had periodic bouts of deflation as well as inflation, with the recent inflationary history from the 1970s possibly an aberration. Of note Federal Reserve chairman Ben Bernanke devoted much of his academic career to studying the causes of the Great Depression. Bernanke famously earned
the moniker of ‘Helicopter Ben,’ when he suggested dropping money from helicopters if the US economy slid into deflation or falling prices, and in doing so he drew on a quote from monetarist Milton Friedman. Critics, who disliked the idea of expanding the money supply in that way, coined the ‘Helicopter Ben’ label.
As well as the control of inflation, the Fed’s mandate also encompasses the generation of full employment. In the US, a core concern is the level of unemployment and, with the June figure at 9.5%, expectations are the Fed is a long way off ending its policy of near-zero interest rates.
Especially worrisome is that, looking at each recession since 1974, it has taken much longer to get back to te previous level of employment with each successive downturn. It is unclear when the unemployment rate is likely to peak and how long it will take to reclaim all of the lost jobs. In addition, there has been a dramatic increase in the number of jobless seeking training, overwhelming retraining programmes.
The composition of the US economy has changed and is now dominated by the services sector. Most past recessions were influenced by changes in inventory. The Fed would raise interest rates, demand would slow, inventories would pile up and manufacturers would reduce output. Subsequently, factories would lay off workers until residual demand reduced the inventories. It was a stop-go manufacturing base. In a changed environment, it remains to be seen whether or not service jobs will return as quickly as they have disappeared.
The ‘non-accelerating inflation rate of unemployment’ or NAIRU is put at 5% until 2020, according to the US Congressional Budget Office, which provides Congress with objective analyses to help with economic and budgetary decisions. (NAIRU is essentially the lowest level of unemployment that, if breached, will lead to rising inflationary pressure.) At 5%, NAIRU is around the point where it has been for the past few decades and represents a lower figure than those found in other G-7 countries. Some economists believe that NAIRU is drifting somewhat higher compared with the past and they peg NAIRU at around 6.0% to 6.5%. A significant increase in NAIRU would risk inflation surprising to the upside sooner as a recovery takes hold.
The output gap is clearly still very real in the US, as evidenced, for instance, by the Institute for Supply Management’s manufacturing index, which underwent one of its sharpest declines in May, although it remained at a high level. Output gap analysis would suggest that all economies have some level of maximum potential GDP growth at any point in time. Analysing the output gap entails measuring the actual output of an economy and the output it could achieve when it is most efficient or at full capacity. A positive output gap, so economic theory suggests, will lead to inflation as production and labour costs rise. During periods when an economy has a large negative output gap, there are typically large amounts of excess labour (unemployment) and excess manufacturing capacity; the supply of goods is abundant, while demand for goods is curtailed according to theory. A combination of these two elements results in low inflation or even deflation.
‘Cold Money’ chills inflation heat
The monetarist view on inflation rests on the phenomenal amount of money that has been created by central banks, including the Fed. The bulk of the ‘money printing’ or ‘quantitative easing’ by the Federal Reserve is actually the US$800bn credited to bank deposits. With this money largely remaining idle, effectively ‘cold money’, there has not been a ‘money multiplier’ effect, which could theoretically have added US$8trillion to a US$14.3 trillion economy. If that were to occur, then the money creation by the Fed would be inflationary. For reasons of both perception and reality, banks have needed to show capital strength and are ‘capital constrained’ from making new loans, dampening the ‘money multiplier’ effect.
Banks are attempting to rebuild their balance sheets by borrowing from the government at very low short rates and investing along the government yield curve. This helps governments fund their deficits and, as long as there is no default, the bank gets its money back as well as a healthy amount of interest during the holding period. While the banks are effectively lending to the government, they are not lending to the rest of the economy. Funds that should flow into the economy via the banking system are merely recycled back into funding government deficits. Japan provides a classic illustration of this concept of ‘cold money’ and what can fail to work. Even though the money base shot up, Japan has not shaken off deflation.
The economic meltdown of 2008 led to a surge in government deficits, as tax revenues fell and governments implemented stimulus spending, particularly to replace the shortfalls of the private sector. Those concerned about inflation point to the size of government deficits, typically at levels last seen at the end of World War II, with the US federal government deficit at around 10% to 12% of GDP. Historically, spikes in debt have contributed to increases in inflation. There is always the temptation for governments to inflate away their liabilities. In the case of the US, for example, were this to happen, both foreign and domestic creditors would share the burden of any higher US inflation. However, creditors are likely to demand appropriately high real interest rates. Potential inflation triggers within the US include healthcare spending as a consequence of government liabilities in the context of an ageing population and healthcare reform. Future governments might choose to renege partially on their liabilities, that is delivering less on both social security and government healthcare programmes. Equally, political leaders may not be able to resist inflating their way out of the problem. In the case of the US, it is worth remembering the country’s spirit of innovation that may help address such problems.
Charting the course with bonds
With economies exhibiting somewhat anaemic growth, hampered by persistently high unemployment and consumers’ seeking to reduce their debts, the outlook for earnings growth is rather mixed. While the lack of growth may not be ideal for equity investors, bond holders are in an attractive part of the credit cycle. The management teams of companies are, for the most part, skillfully navigating the weak economy and capital markets, placing the safety of companies ahead of shareholder pressures.
Companies have been using reasonably healthy earnings to deleverage balance sheets and extend near-term liabilities. With the prevailing uncertainty for growth and inflation, G-3 government bonds, deficits notwithstanding, offer a measure of ‘safe-haven’ status. Were inflation to make a reappearance, the spread between high yield bonds and higher rated issuers, such as Treasuries, would be expected to close as inflation heats up. This may prove beneficial for high yield bond holders who, having chosen their issues conservatively, would gain from the interest-rate premium inherent in high yield bonds, and from any capital appreciation in prices as spreads tighten.
Although inflationary pressures are arguably some way off, in our view, vigilance is required. Inflation may become a problem in the G-7 economies when balance sheets have been repaired in the banking sector and household finances are healthier, and credit demand and supply once again rise. How governments go about withdrawing stimulus will be a good determinant of inflation trends.
