The Muddle Through Economy, R.I.P.?

Muddle Through, R.I.P?
Savings Equal Investments
Japanese Disease
Who Will Buy the Debt?
The New Muddle Through Economy

I first wrote about the Muddle Through Economy in 2002, and the term has more or less become a theme we have returned to from time to time. In 2007 I wrote that we would indeed get back to a Muddle Through Economy after the end of the coming recession. If you Google the term, at least for the first four pages, more than half the references are to this e-letter. I get a lot of flak from both bulls and bears about being either too optimistic or too pessimistic. Being in the muddle through middle is comfortable to me.

Last week I expressed my concern that we as a country are taking actions that could indeed "Kill the Goose" of our free-market economy. I rightly got letters asking me how I could maintain Muddle Through in the face of that letter. I have given it a lot of thought and research. How likely are we to muddle through in the face of $1.5 trillion and larger deficits? Today we take another look at Muddle Through. It should be interesting.

Muddle Through, R.I.P.?

I defined a Muddle Through Economy in the past as one of slow growth (in the area of 1-2%) and a slack employment environment, such as we had in 2002 and the early part of 2003. In early 2007, I suggested we would return at some point to such an environment at the end of the recession I was predicting.

I am not surprised about the response of the Fed to the current recession and credit crisis, whether it's the large monetization of debt or the low interest rates. Assuming they more or less remove the monetary easing in a reasonable manner, there is nothing that would make me think we do not eventually recover, albeit at a very slow Muddle Through pace, with a jobless recovery that lasts for several years. It will not be pleasant, but we'll survive.

However, gentle reader, never in my wildest dreams did I think we could be looking at government deficits of $1.5 trillion dollars and actually budgeting future deficits of over $1 trillion as far as the eye can see. And there is real reason to think that under current plans, $1 trillion deficits are optimistic. Look at the graph above from the Heritage Foundation. They suggest that current policy would bring us closer to a $2 trillion deficit by 2019.

And that assumes nominal growth that is north of 3% and unemployment dropping back below 5% in reasonably short order. If you make less optimistic assumptions, the number can become much larger rather quickly. Where do we find that much money to finance that large a deficit? We will look at what might be the answer, but first we need to look at a basic concept in economics.

Savings Equal Investments

GDP (Gross Domestic Product) is defined as Consumption (C) plus Investment (I) plus Government Spending (G) plus [Exports (E) minus Imports (I)] or:

GDP = C + I + G + (E-I)

(For the wonks out there, GDP is usually termed "Y".)

You can calculate national savings as GDP minus consumption and government spending. That means that investment equals savings plus net exports. If there are no net exports, then money must come back into the US from outside the country to finance investments, along with savings.

This equation is known as an identity. An identity is an equality that remains true regardless of the values of any variables that appear within it. That means it is not a guess or an approximation. It is simple reality.

Thus, if there is a government deficit, there must be savings by both consumers and businesses, plus capital flows from outside the country, to offset that deficit in order for there to be any money left over for investments.

In the short run, an increase in government spending can offset a decline in consumption (a recession), but absent savings a government deficit crowds out investment in the long run. There must be savings in order for there to be investment. And without investment, you do not get job growth or economic growth.

Japanese Disease

Some readers wrote this week telling me I am far too worried about a rising government deficit. Right now we are at roughly 42% of debt to GDP. In 1989, at the start of the lost decades, Japan had a debt-to-GDP ratio of 51%. Now it is at 178%, and the world has not come to an end for them. In fact, they are running massive government deficits today and plan to do so for a long time. Why, I am asked, can't we be like Japan? And my answer is that it is possible, but the cost that Japan has paid has been high.

In 1989, private Japanese debt (businesses and consumers) was at a debt-to-GDP ratio of 212%. Now it is at 110%. And the total of both government and private debt is roughly the same (within 5%) of where it was 20 years ago. Along with running large trade surpluses, private debt has been exchanged for government debt. Savings have fallen from the mid-teens to about 2% today, as the country is rapidly aging and now using its savings to live on. And how much has all that government spending helped the country? Before I answer that, read these paragraphs from Hoisington Asset Management's latest letter (last week's Outside the Box):

The federal government's promise to extricate the U.S. economy from this recession involves more spending (increasing public debt) and more subsidies for consumers, such as car rebates and home buying incentives (more private debt). In other words, more debt is supposed to solve the problem of over-indebtedness. The truth is that this policy merely indentures its citizens further without providing any income for repayment of debt. In previous letters we have discussed the fact that the government spending multiplier is zero (read Professor Robert Barro's book, Macroeconomics - a Modern Approach, p. 370).

This means there is no long term income benefit from stimulus programs. According to the latest academic research, the most recent $800 billion stimulus plan will boost economic activity in the short run, but will surely depress economic activity over time. The government problem is complicated by the fact that the tax multiplier is 3, meaning that a 1% change in taxes will change GDP by about 3% over time. More recent research (Barro & Redlick, September 2009, "NBER Working Paper 15369") suggests that a 1% cut in the marginal tax rate would raise GDP in the ensuing year by 0.6%. With the deficit rising due to a zero spending multiplier, the tendency will be to try to raise taxes to pay for this higher level of expenditures, which will further depress aggregate spending and output.

For all intents and purposes, Japan has had no growth for almost two decades. Their nominal GDP is where it was 17 years ago, and the number of employed people is at 20-years-ago levels. An aging population has masked their unemployment problems, as older citizens retire. Their savings went to government debt. Taxes were raised numerous times. Since government deficit spending has no long-term multiplier effect, growth has been nonexistent. (By the way, that research about multiplier effects has also been done by Christina Romer, the chairman of the current President's Council of Economic Advisors, and further explored by European economists. There is general agreement on these facts.)

In 1998, the US had a total debt- (government plus private) to-GDP ratio of 260%. Today it is 373%. We have added over $15 trillion in debt, yet total employment today is roughly where it was 9 years ago. But the current economic leadership wants to solve the problem of too much debt with even more debt. I am sympathetic with the idea that in the short run the government should step in and the Fed should print (within limits) money to keep us from deflation. But the equation we spent time on earlier suggests that if we continue to run massive deficits, we run the risk of catching Japanese disease - a decade-long (or longer) period of slow growth and high unemployment, especially since our population is growing and our Boomers are going back to work (and surveys suggest they intend to work longer).

Large government deficits choke off the very investment that we need to create jobs. In the name of doing good, the unintended consequence is to make it more difficult for small businesses to start up and create jobs. And we all know that small business is the engine for job creation.

The way out of the current morass is to create jobs and increase productivity. But if the government runs deficits of $1.5 trillion, that means whatever savings (corporate and consumer) we have will not go into the investments we need, but into government debt.

Who Will Buy the Debt?

Now, let's go back to the problem of who will buy the debt. How can we find $1.5 trillion each and every year? Some of it will come from foreign central banks, as we continue to run a trade deficit. Once those dollars leave our shores, they do not disappear. They can only go back into a dollar-denominated investment. Up to now, that has typically been US government debt. If China decides to use its dollars to buy commodities or other assets, whoever sells them the assets now has the dollars and must decide what to do with them. So give or take a few billion, about $400 billion will come back to the US from our trade deficit next year. That still leaves $1.1 trillion.

Upon reflection, and cutting to the chase, I think that the buyers of the debt could be US banks for quite some time. The next graph (click to enlarge) shows commercial and industrial loans at US banks falling precipitously. Banks have (correctly) tightened lending standards, but that means that small and medium-sized businesses, which account for over 85% of all jobs, have been cut off from the life blood of growth. Is it any wonder they are cutting jobs at a prodigious rate?

The next graph (click to enlarge) shows bank credit (of all types), going back to 1974. Notice that even during recessions (gray shaded areas) bank lending either grows or at the most goes flat. But now we are experiencing something new: bank lending is falling. Notice the sharp increase in lending in 2008 as corporations decided to draw down their banks' lines of credit, afraid that the banks might cut back. And with good reason, as banks did exactly that.

So where do banks put their cash and reserves they are not lending? At the Fed and in Treasury debt. If you can leverage capital at ten to one (as banks can) and if you get 2% (for longer-term debt) and if you only have costs of, say, 50 basis points (or 0.5%), you can make a return on equity of 15% with no risk.

And that is what we are seeing. Banks are taking the money the Fed is printing and the government is giving them and putting it back at the Fed. Bank reserves at the Fed are exploding. And they are likely to continue to do so, since bank balance sheets are still deteriorating, especially at smaller and regional banks exposed to commercial real estate loans. Banks own 45% of commercial real estate loans, compared to only 21% of single-family loans. Banks (in general) are going to have to raise capital and reduce their loan portfolios in order to keep within the guidelines for adequate reserve capital. Small wonder that my friend Chris Whalen (one of the real experts on banks) thinks we will see over 400 banks fail in this cycle.

One quick chart to further highlight the problem that banks are facing. I have been writing for several years that commercial real estate loans will be the next shoe to drop. Moody's calculates that commercial real estate prices have dropped 30%. Over a trillion dollars in commercial real estate loans are coming due in the next few years. Banks are going to continue to reduce their loan portfolios in order to deal with the massive write-offs they are going to have to make. And my bet is they put those reserves they are not lending into government debt.

Given that the current Congress is hell bent on massively raising taxes in 2011, we are likely to dip back into recession by then, if not before. Remember, taxes have a multiplier effect of three. That means tax cuts increase GDP (over time) by three times their amount. But tax increases reduce GDP by three times the increase. That will make deficits worse, and unemployment will again start to rise from already high levels. Twenty states have already raised sales taxes, and more are raising other taxes. It is a vicious spiral.

The New Muddle Through Economy

This is not a prescription for a return to normal growth. We are headed for a New Normal that is less than what the market currently believes. Unless the deficit comes under control at some point, we face the real prospect of catching Japanese Disease and suffering yet another lost decade. Can we Muddle Through? We have no choice but to do so. But it will not be fun. It will not be long-term 2% growth and employment going back to 6% any time soon. Can we reverse the course? With a different attitude and leadership in Congress, maybe we can. But it won't happen next year, and it's unlikely in 2011.

I am afraid we will have to put my old friend Muddle Through, as I previously defined him, back in his box for a while. But wait, if my friend at PIMCO, Mohammed El-Erian, can tell us we are going to a "New Normal," then I can decide that we are going to a "New Muddle Through Economy." Just not one as benign as I used to think.

In the end, that is what we will do. We will figure out how to deal with the environment in which we find ourselves. That is what free markets and entrepreneurs do. Things will sort out, but not before we have what could be an even more difficult crisis, which will force us to make hard choices.

As an aside, I am not expecting that we will see the crisis I am thinking of any time soon. We can move along with positive GDP for some time. I am thinking of the longer term, 1-3 years out. We will become complacent. I will get letters telling me I am too pessimistic. Just as I did in late 2006 when I said we would be in a recession by late 2007. But I firmly believe we will see a double-dip recession within another 18 months (at the most). Stock markets drop on average about 40% in a recession. Adjust your portfolios accordingly.

Disclaimer: John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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Comments

[Dave Wrixon:]

If you are able to muddle through with current policies, you will already be ahead of the game.

Oct 18 10:54 AM

[dracula99:]

Remember when the Left was warning the Right that by starting fictitious wars, neglecting the economy, cuting taxes for the rich, outsourcing, not regulating wall street, we were going to pay for these mistakes for a generation to come? That's what's happenig now. Suck it up and put the blame squarely on the Republicans, starting with that idiot Reagan.

Oct 18 01:50 PM

[ebworthen:]

Short version: The average person will get the shaft coming and going.

The banks will raise fees, rates, yet pay less for money in savings.
The responsible will be forced to use what savings they have to pay for increased taxes, which were (are) a result of bailing out the financial institutions that squandered the savings and investments of the same responsible citizens.

The Japanese have a very monoculture, cohesive, and obedient citizenry in comparison to the US - and they are an island.

I have trouble seeing us muddle through with quite the same placidity of the Japanese; and part of me hopes we won't.

Muddling through as an indentured servant to financial oligarchs and a corrupt oppressive government leaves a bad taste in my mouth.

"Live free or die" is more appealing to me, but the muddling mediocrity or our somnambulent citizenry so far appears to enjoy the yoke of servitude and slavery.

Oct 18 01:55 PM

[ebworthen:]

Oh dear.

Politics is the distraction.

It serves their purposes to have you bayonet a straw man.

Politicians and bankers are more than happy to have the citizenry chasing ghosts and fishing for red herrings; it makes it easier to keep you pulling the plow in their field.


On Oct 18 01:50 PM dracula99 wrote:

> Remember when the Left was warning the Right that by starting fictitious
> wars, neglecting the economy, cuting taxes for the rich, outsourcing,
> not regulating wall street, we were going to pay for these mistakes
> for a generation to come? That's what's happenig now. Suck it up
> and put the blame squarely on the Republicans, starting with that
> idiot Reagan.

Oct 18 01:59 PM

[Graham and ...:]

Japan finally got its debt down to manageable levels. But it took over a decade of stagnation.

We're just beginning OUR decade (plus).

Oct 18 03:36 PM

[rbblum:]

Why not be like Japan? Possibly because Japan's overall popoluation is decreasing while its senior citizens segment is growing. And, it does not help to have Japan's GDP so heavily dependent on the strategy of exporting manufactured goods, which has been decreasing. . . But worse, the new government of Japan believes they can extend more social programs which needs more borowing. . . which will lead to payback time (economic straits) in the year 2010.

Somehow, lack of solid and sensible fiscal and monetary policy is not only found in the US. . . which can not flourish if the business environment is polluted with a lack of understanding that the government that governs least IS the best.

Oct 18 08:30 PM

[Ray:]

The left enabled the right and the right enabled the left. The longer you ignore those basic facts and believe that one party cares more than the other party the longer the same problems will persist. Neither party cares and, I can say this with confidence, Democrats are just as guilty as Republicans. Blind partisan politics is the problem and comments like this adds to the problem not to the solution.


On Oct 18 01:50 PM dracula99 wrote:

> Remember when the Left was warning the Right that by starting fictitious
> wars, neglecting the economy, cuting taxes for the rich, outsourcing,
> not regulating wall street, we were going to pay for these mistakes
> for a generation to come? That's what's happenig now. Suck it up
> and put the blame squarely on the Republicans, starting with that
> idiot Reagan.

Oct 18 08:57 PM

[Mayascribe:]

John: No muddling around here. Great article. With the spiraling deficits, and increased pressure on small businesses, because of tightened lending, there's no doubt that we're in for another major downturn; only, the "next leg down," might even be worse than the first leg down. Then the real muddling begins.

Oct 19 08:17 AM

[dracula99:]

Sure, both parties are to blame, but its time to stand behind a party that NOW its willing to battle real problems facing our countries, instead of concentrating on garbage like abortion, christianity, the threat of Islam....and other crap like that. This country needs to build its manufacturing base and stop squandering BILLIONS on defense, the war on drugs, entitrlement programs for ex-military (how do you like them apples?). If every company of 10 or more employees agreed to take a 10% pay cut and hire an eleventh employee, the world would be a better place, the employees would be happier and unemployment would plummet. These are solutions that only the left thinks about. The Right is too busy proclaiming that competition is paramount(until other countries beat us, then they complain of unfair advantage).

Oct 19 08:39 AM

[TripleG:]

Great article. Question is: How do we stop the Congress and White House from making the disease worse? I'm at a loss on how any of this can be turned around. The Obamas feel they have a public mandate to destroy the USD.

Oct 19 09:23 AM

[One Eyed Guide:]

Hmm? Where does this multiplier nonsense come from?

"By the way, that research about multiplier effects has also been done by Christina Romer, the chairman of the current President's Council of Economic Advisors, and further explored by European economists. There is general agreement on these facts."

Could you post exactly where Romer said the multiplier was effect was zero (or 1, which is what I think you meant)?
In a simple Google search, it is easy to see there is no agreement on multiplier effects. In fact, Romer specifically believes that the multiplier effect on tax cuts and spending is the same and variable dependent on the current situation. They both lead to deficits so why would they be different? (gold star if you can answer this without asking a Keynesian or behavioral economist. Hint: How do consumers behave?)

Barro's research on multipliers has no validity because he either excluded all the periods that had a positive multiplier or average long periods to hide it. Don't ask me why, he must know what he is doing as he is a Harvard Prof and is widely criticized by the academic community for this.

Romer's research shows that tax increases to eliminate an inherited deficit have a positive multiplier so the answer to the debt problem is to raise taxes once the economy is approaching full employment (not before so this means that banks need to be cleaned up before raising taxes. Raising taxes without fixing the banks is another Japan mistake.)

Agreement: You're right that there is probably going to be a double dip recession but it is purely a result of bank balance sheets not being cleaned of toxic wastes so they can lend. We might avoid a "W" if the banks go bust fast enough but this is unlikely. Citibank's problems do give some hope of this.

Oct 19 11:43 AM

[searcher:]

Left-Right. Please! Most of the ‘Right’ can accept the discomfort of others with equanimity; most of the ‘Left’ cannot accept the comfort of others with equanimity. The ‘Right’ is jealous of its accumulations and prerogatives; the ‘Left’ is envious of same. Clearly, Justice rarely visits either wing. That is why the battle is eternal.

Oct 19 01:08 PM

[Tony Daltorio:]

You are deluded if you the Dumbocrats are confronting the REAL problems facing this country - Look at how the Obama administration folded like an accordion on meaningful financial reform - face reality - BOTH parties are corrupt and have been bought and paid for by Wall Street!


On Oct 19 08:39 AM dracula99 wrote:

> Sure, both parties are to blame, but its time to stand behind a party
> that NOW its willing to battle real problems facing our countries,
> instead of concentrating on garbage like abortion, christianity,
> the threat of Islam....and other crap like that. This country needs
> to build its manufacturing base and stop squandering BILLIONS on
> defense, the war on drugs, entitrlement programs for ex-military
> (how do you like them apples?). If every company of 10 or more employees
> agreed to take a 10% pay cut and hire an eleventh employee, the world
> would be a better place, the employees would be happier and unemployment
> would plummet. These are solutions that only the left thinks about.
> The Right is too busy proclaiming that competition is paramount(until
> other countries beat us, then they complain of unfair advantage).

Oct 19 07:12 PM

[dracula99:]

Obama has been in office 10 months, you morons!The Wall Street abuse has been encouraged by the so call free-market idiots like you. You bow to the free- market ideology, but you forget that the world has caught up to the rape perpetrated by the good ol' US of A after wwII. Time to think of how to invest in your country instead make a quick buck from the ebbs and flows of this travesty called the stock market.

Oct 19 07:59 PM

[2houndz:]

Go shout your nonsense at HuffPo where they prefer nonsensical baiting and badgering.

I come to this website to read articles by the likes of John Maulden, and to read comments by those who have something meaningful to add.

If you don't mind, I'd like to have back the three minutes of my life that I spent reading your drivel. You don't even have a point to make.


On Oct 19 07:59 PM dracula99 wrote:

> Obama has been in office 10 months, you morons!The Wall Street abuse
> has been encouraged by the so call free-market idiots like you. You
> bow to the free- market ideology, but you forget that the world has
> caught up to the rape perpetrated by the good ol' US of A after wwII.
> Time to think of how to invest in your country instead make a quick
> buck from the ebbs and flows of this travesty called the stock market.

Oct 19 10:08 PM

[OldSusanna:]

For nearly 100 years the progressives have worked diligently to undermine the natural order of personal accountability, familial cohesion and free-market capitalism. Republicans AND Democrats alike: rigid progressive ideology blinding them to the differences between protecting (all citizens from threats, malfeasance and toxicities) and controlling (consumers, financial and trade). We all need to acknowledge our contribution (however large or small) to this current mess and make a conscious effort to work toward better (more informed) financial and life decisions. ...And, just as important: ditch all the incumbents!

Oct 19 11:02 PM

[Swiftcreek1:]

There's always one socialist loon in the room......

Why not ask 9 of your friends at work if they are willing to take a 10% pay cut right along with you......Assuming you could find them there would be no positive net effect on the economy since you've done nothing but take money from 10 people to give to the 11th......that and reduce productivity by 9.111% per person since our fictitious company didn't have a need for the 11th guy you created the job for.....Thinking like yours is why the Soviet Union's (and every other country that has tried it) grand experiment with communism was a dismal failure.


On Oct 18 01:50 PM dracula99 wrote:

> Remember when the Left was warning the Right that by starting fictitious
> wars, neglecting the economy, cuting taxes for the rich, outsourcing,
> not regulating wall street, we were going to pay for these mistakes
> for a generation to come? That's what's happenig now. Suck it up
> and put the blame squarely on the Republicans, starting with that
> idiot Reagan.

Oct 19 11:14 PM

[Chancer:]

Assuming Obama gets a second term, I continue to believe the Democrats will give us a value-added-tax (VAT). This will be sold to the American people as necessary to pay for down the deficit. Pelosi has publicly advocated for the VAT as a means to "level the playing field with Europe." That argument is that it is "unfair" that we should have lower taxes and a higher standard of living than Europeans- most of whom rent (less home ownership) and use public transit (less auto ownership).

Re. income tax, there is not enough to get all from the rich over $250K in income. Major tax increases on the middle class would be seen as breaking Democrat campaign promises and result in losing middle class votes and perhaps the Democrat monoploy on power.

This is why a believe the Democrats must enact a VAT.

Oct 20 03:28 PM