Editor's note: Originally published on 26 June, 2014
Yesterday, I discussed the real use of economic data when it comes to investing. However, it was extremely interesting to see the vast amount of analysis being done to dismiss the dismal Q1 report and push the "hope" of a better tomorrow. It was in this context that Mohammed El-Erian made a very astute comment:
"As analysts scramble to explain away this morning's sharp and unfavorable revision to the first-quarter's gross domestic product, it's tempting to dismiss that 2.9 percent drop given that weaknesses in the health-care sector was a major driver of the contraction...
Overall, the first-quarter drop - the worst in five years - involved very broad sectorial weaknesses that spoke too much more than the negative impact of bad weather and industry-specific factors like health care. It also points to underlying economic conditions that remain weak and concerning despite several years of healing facilitated by exceptionally accommodative monetary policy."
Since the end of the financial crisis, economists, analysts and the Federal Reserve have continued to predict a return to higher levels of economic growth. As I showed in my discussion of the Fed's forecasts, these predictions have continued to fall short of reality.
However, the issue is much greater than just a "post-financial crisis" malaise.
"Since 1999, the annual real economic growth rate has run at 1.94%, which is the lowest growth rate in history including the 'Great Depression.' I have broken down economic growth into major cycles for clarity."
While economists, politicians and analysts point to current data points and primarily coincident indicators to create a "bullish spin" for the investing public, the underlying deterioration in economic prosperity is a much more important long-term concern. The question that we should be asking is "why is this happening?"
From 1950-1980 nominal GDP grew at an annualized rate of 7.55%. This was accomplished with a total credit market debt to GDP ratio of less 150%. The CRITICAL factor to note is that economic growth was trending higher during this span going from roughly 5% to a peak of nearly 15%. There was a couple of reasons for this. First, lower levels of debt allowed for personal savings to remain robust which fueled productive investment in the economy. Secondly, the economy was focused primarily in production and manufacturing which has a high multiplier effect on the economy. This feat of growth also occurred in the face of steadily rising interest rates which peaked with economic expansion in 1980.
However, beginning in 1980 the shift of the economic makeup from a manufacturing and production based economy to a service and finance economy, where there is a low economic multiplier, is partially responsible for this transformation. The decline in economic output was further exacerbated by increased productivity through technological advances and outsourcing of manufacturing which plagued the economy with steadily decreasing wages. Unlike the steadily growing economic environment prior to 1980; the post 1980 economy was experienced by a steady decline. Therefore, a statement that the economy has had an average growth of X% since 1980 is grossly misleading. The trend of the growth is far more important, and telling, than the average growth rate over time.
This decline in economic growth over the past 30 years has kept the average American struggling to maintain their standard of living. As their wages declined, they were forced to turn to credit to fill the gap in maintaining their current standard of living. This demand for credit became the new breeding ground for the finance based economy. Easier credit terms, lower interest rates, easier lending standards and less regulation fueled the continued consumption boom. By the end of 2007, the household debt outstanding had surged to 140% of GDP. It was only a function of time until the collapse in the "house built of credit cards" occurred.
This is why the economic prosperity of the last 30 years has been a fantasy. While America, at least on the surface, was the envy of the world for its apparent success and prosperity; the underlying cancer of debt expansion and declining wages was eating away at its core. The only way to maintain the "standard of living" that Americans were told they "deserved," was to utilize ever increasing levels of debt. The now deregulated financial institutions were only too happy to provide that "credit" as it was a financial windfall of mass proportions.
The massive indulgence in debt, what the Austrians refer to as a "credit induced boom," has likely reached its inevitable conclusion. The unsustainable credit-sourced boom, which led to artificially stimulated borrowing, has continued to seek out ever diminishing investment opportunities. Ultimately these diminished investment opportunities repeatedly lead to widespread mal-investments. Not surprisingly, we clearly saw it play out "real-time" in everything from subprime mortgages to derivative instruments which were only for the purpose of milking the system of every potential penny regardless of the apparent underlying risk. We see it playing out again in the "chase for yield" in everything from junk bonds to equities. Not surprisingly, the end result will not be any different.
When credit creation can no longer be sustained, the process of clearing the excesses must be completed before the cycle can resume. It is only then, (and it must be allowed to happen), can resources be reallocated back towards more efficient uses. This is why all the efforts of Keynesian policies to stimulate growth in the economy have ultimately failed. Those fiscal and monetary policies, from TARP and QE to tax cuts, only delay the clearing process. Ultimately, that delay only potentially worsens the inevitable clearing process.
The clearing process is going to be very substantial. The economy currently requires $2.75 of debt to create $1 of real (inflation adjusted) economic growth. A reversion to a structurally manageable level of debt* would require in excess of $35 Trillion in debt reduction. The economic drag from such a reduction would be dramatic while the clearing process occurs.
*Structural Debt Level - Estimated trend of debt growth in a normalized economic environment which would be supportive of economic growth levels of 150% of debt-to-GDP.
This is one of the primary reasons why economic growth will continue to run at lower levels going into the future. We will continue to observe an economy plagued by more frequent recessionary spats, more volatile equity market returns and a stagflationary environment as wages remain suppressed while costs of living rise. Ultimately, it is the process of clearing the excess debt levels that will allow personal savings rates to return to levels that can promote productive investment, production and consumption.
The end game of three decades of excess is upon us, and we can't deny the weight of the debt imbalances that are currently in play. The medicine that the current administration is prescribing is a treatment for the common cold; in this case a normal business cycle recession. The problem is that the patient is suffering from a "debt cancer," and until the proper treatment is prescribed and implemented; the patient will most likely continue to suffer.