Two big dangers are manifesting themselves, the lack of consumer demand and rising interest rates.
We've already been warning for quite some time about rising interest rates. There are so many government bonds arriving at the markets, demand for them (especially from abroad as both the dollar and the US fiscal position are seen as vulnerable) might be somewhat problematic. To an extent, reduced foreign appetite will be made up by increased domestic buying as the American savings rate is increasing, but enthusiasm might be limited because of inflation fears, which are never good for bonds.
This is because the present economic situation which is characterized by highly indebted balance sheet has much to gain from mild inflation, so interest rates will rise to make up for increased inflationary expectations and this is already starting. We can only hope they don't rise to levels where they snuff out any recovery, however weak, but this is a serious risk.
Another risk has some relation to this: governments and central banks everywhere are spending and creating money to fill the large gaps in demand as consumption and investment have fallen because of the credit crisis and weak balance sheets. The idea is that at some point, this will create enough economic activity as to be self-sustaining, that is, more or less normal levels of private consumption and investment will take over from the public spending in generating economic activity further.
The only sign that this could happen is increased consumer confidence in America. But there are numerous problems here:
- The US dollar is weak, and is likely to get weaker still, giving that American consumer on which much of the rest of the world has relied upon to a considerable extent less and less bang for their buck. A tell-tale sign: American imports are falling at a heavy (20%+) pace.
- Unemployment is rising, which has a direct effect on consumption, but also an indirect effect, as many more working people fear getting laid off and cutback spending
- Much of the consumer boom in the US (but also in the UK and other countries) was credit induced and based on rising house prices. These mechanisms have gone in reverse, and it doesn't look like the overdrive of negative savings and mortgage induced spending will return any time soon (and in fact, in itself that is a good thing)
- Consumers in other countries are not likely to fill in the void left by the American consumer, at least not nearly to the same extent.
- Japan, Germany and the rest of Europe is in at least as big a funk as the US (if not bigger), and they have stagnant (or even shrinking) populations which are fast getting older
- There are a few places where economic growth still is in place, most notably China and India, but the first has a soft currency limiting imports and demand is increasingly dependent on the public sector while the latter, although surprising on the upside this week, is much less integrated in the world economy then China.
So where is the demand supposed to come from after the public stimulus programs have ran their courses? We think the most developed countries at least will experience a pretty prolonged period of lackluster economic growth at best, possibly even prolonged recession.
The latter is the real danger, because if the recession continues for some time, public spending will hit the limits of fiscal sustainability. This is already happening in countries like Iceland, Spain, Ireland and quite likely the UK and Italy, possibly Japan as well.
If that happened in America and continental Europe, well, then things would really turn ugly.