Over the last years, there are numerous developments that are noteworthy, and it's useful to combine quite a few of these together to see whether any clear picture emerges. Sometimes, a picture says more than a 1000 words, let alone quite a few pictures together.
Our version is one where underlying problems in the US economy aren't really addressed and too much burden falls on monetary policy to keep the economy humming. This is unfortunate, as monetary policy isn't very effective under the present circumstances.
The present conditions are very friendly to shares, but if the underlying problems in the US economy aren't addressed, this honeymoon might not last.
This is a rather remarkable chart. It means that most wages haven't seen much gains for quite some time, even when it's undeniable gains have been made (productivity has continued to go up). These gains have mostly gone to the top.
More recent is a trend shift from wages to profits:
2. Personal savings
You see a steady decline until the 2008 crisis struck and savings have partially recovered. It looks like many households tapped into savings to share in the wealth creation they saw around them, and this is not all.
3. Private sector debt
You see a steady rise in household debt, not only did households tap into savings, they increasingly relied on borrowing. What you also see is a fall in household debt after the crisis, or deleveraging household balance sheets. We'll get back to that below.
4. House prices
First a rise, then a fall, wiping off $9 trillion from household balance sheets, no wonder they started paying down debt and borrowing less. The collapse in house prices produced other ripple effects besides destroying household balance sheets, most notably in the financial sector, hence the economic crisis.
5. The crisis, quick reversal
The 2008 crisis was a typical asset bubble deflation, this is different from your garden variety business cycle. It's similar to what happened in the early 1930s and in Japan after 1990. However, you see below that world output, trade, and stock markets fell as fast or faster compared to the 1930s, but then, all of a sudden, that fall was arrested and reversed.
6. Actual and potential output
While there was a quick reversal of a crash that was as bad, or worse, as that of the early 1930s, the quick reversal is quite noteworthy. However, economic performance has been rather tepid, as can be seen from the graph below, which shows a significant gap between potential and actual output.
This means that although there was a quick reversal, after that the economy didn't perform as well as it could, as many productive resources (labor, plant, machinery, etc.) weren't employed (potential output is the estimated output resulting from employing all available productive resources).
More worrying still is the rising gap between potential output and the trend growth pre-crisis (we have dealt with that issue here)
7. Economic recoveries compared
It's also worthwhile to take an international prospect, here is a table from The Economist which shows that the US recovery, even when output hasn't, was better than other countries.
8. Labor market
The latter figure shows that the fall in employment was not as dramatic as in previous financial crisis. However, for the US there is still a remarkable development:
This graph shows that all is not well, a large number of people are simply withdrawing from the labor market.
9. Private sector surplus
The next graph is a combination of things we've already seen (mostly), but nevertheless a rather striking graph is the result.
You see a blue line, representing the private sector financial surplus (or deficit, as before the crisis). This is simply the confrontation of what the private sector saves (S) minus what it invests (I). You see that the financial crisis had a rather dramatic impact on the private sector financial balance.
In fact, someone not trained in economics might conclude there wasn't any crisis at all as the private sector moves into a huge surplus! Such surplus means nothing more and nothing less, that the private sector saves way more than it invests, that is, it generates a savings surplus.
You see something else that is striking, the correlation with unemployment is awesome. When the private sector moves into surplus, it becomes a net saver and money is being withdrawn from the economy. Unless some other sector compensates for this, economic activity will take a hit.
From the rise in unemployment you can already assess that economic activity indeed took a hit, so apparently there was insufficient compensation, which can either come through international trade (via a trade surplus) or the public sector (a public sector deficit).
10. Public sector deficit
There was indeed a considerable degree of compensation from the public sector, especially immediately after the crisis. But policy reversed, as people began to worry about public deficits and debts.
This is clear both from the rapid decline of the deficit itself (first graph) and the net contribution of the public sector to economic activity (second graph).
The graph above shows how public spending increases and tax cuts added to economic activity in 2009 and 2010 (largely through the big stimulus bill), but austerity (spending cuts and/or tax hikes) took hold and created a drag on activity.
Despite many people warning, inflation and inflationary expectations remain very low. This is rather remarkable in the light of the following figures.
The Fed has slashed interest rates to zero, and that's not all:
13. Monetary base
There is a really noteworthy rise in commercial bank reserves (which, together with currency in circulation, form the monetary base). This has been the result of asset purchases by the Fed (QE1&2&3).
14. Credit creation/ US bank lending
However, flushing the banks with reserves hasn't actually done all that much for credit creation as you can see in the figure below from Richard Koo, the expert from Nomura.
You see that private debt levels are sinking, the private sector is deleveraging. We believe that this is the main headwind in the US economy, and a recovery from a financial crisis always takes a lot of time as the process of shedding debt from balance sheets is slow and grinding.
And just to stress how different the present crisis is from previous ones, you see what happened to real household debt in the wake of different crisis.
It didn't help that fiscal policy shot in reverse and QE isn't terribly effective (it clearly doesn't have a major influence on bond yields and mainly result in bank reserves accumulating).
We think any model or narrative of the economy has to be able to explain most of these stylized facts. We have our own narrative which we think is consistent with the data presented above. Here is a summary:
- Wages lagging productivity is a potential threat to demand
- That threat was masked by lower savings and higher borrowing, supported by rising house prices
- When house prices collapsed, a financial meltdown threatened, but this was arrested by quick policy reaction
- However, household balance sheets took a big ($9+ trillion) hit, leading households to increase saving and reduce borrowing and spending. As a result, the whole private sector moved into surplus which was insufficiently compensated by the public sector
- The public sector financial position should be seen in tandem with the private sector balance to avoid debt-deflationary spirals that plagued the 1930s
- The initial policy reaction prevented a debt-deflationary spiral, and stabilized the economy
- However, fiscal policy reversals and the ineffectiveness of QE have provided insufficient support when the private sector is still deleveraging, resulting in sub-par growth, a large gap between actual and potential output, and increasingly affecting potential output as well, resulting in people withdrawing from the labor market altogether and lower future growth
- The risks that some people attach to expansionary policies, in the form of exploding deficits, inflation, and bond yields, have so far not materialized.
- With employment down, wages stagnating, households still deleveraging and the public sector being a net drag on growth, monetary policy has to do way too much in trying to rebalance supply and demand.
All this is good for investors, for now. Whether that lasts is quite another matter as this situation doesn't create sufficient demand. This gap between supply and demand was first filled by running down savings and running up debt.
That led to the financial crisis and private sector deleveraging. Now, monetary policy has to fill that gap, and it's ill suited to that role under these circumstances.
While we believe that the Fed will only exit QE if actual and potential output are much closer, but we're afraid this gap is closed more by the damage this gap is doing to potential output.
This means that the boom times on the markets can last some more, but at the cost of longer-term growth potential.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.