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Nikhil Raheja's  Instablog

Nikhil Raheja
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Work in the Healthcare Industry. I have an interest in small and mid cap stocks, and buy them for the long term. Been at it for a couple of years.
My company:
kmnk
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seeking alpha
  • Future of the US economy 0 comments
    Jun 6, 2010 4:44 PM
    In an earlier post, it was noted that the key challenges facing the economy were extremely high personal indebtedness, and a multi-decade peaking of optimism. Both factors have held sway ever since, and have kept the supply and demand for capital limited. In addition, the recent turmoil in Europe over the Greek government’s inability to service its debt has raised the fears of a spread of the crisis to the rest of the world.
    While it is difficult to call the short term movements in the asset markets, it is not too hard to be prescient about the multi-generational changes facing the US economy. The US economy should see a repeat of the Great Depression during the coming years, culminating in many lost fortunes, and leading to many new ones. There are several reasons that strengthen the case for such a scenario; a few of those are listed below:
    One of the good measures of the health of an economy is its Money Supply. A growing Money Stock provides a preliminary signal of growing opportunities for production and consumption. A growing economy must always be assisted with a growing money supply, or else the prices fall and cause the financial institutions to recover less than their invested capital.
    The broader Money supply (M2) has been rather stagnant over the last few years, and has shown little resilience despite rising banks’ profits and increasing investor sentiment. This measure of money supply tracks the total deposits at banks as well as the currency in circulation. A little known fact about banking is that the amount of deposits at banks is a reflection of the total lending in the system, since the money lent out is redeposited at the bank, increasing the total amount of deposits.
    As long as growth in M2 remains weak, the potential for growth in the economy will also remain weak.





    One of the biggest reasons for pessimism over future economic prospects is the high Household debt in the country. As history suggests, high household debt has always led to lower borrowing and personal consumption, leading to lower revenues for the businesses. Such fear always contributes to a fear of further losses, thus causing the total production to fall.
    Household debt has fallen only marginally since the start of the crisis. The total household debt must fall from the current $13.5 trillion to around $5 trillion before debt can be expected to start growing again. In addition, the Savings rate must rise significantly above the current 3% to effect this change.





    The trade balance of a country can help alleviate the pain originating from a deflationary crisis. However, a country with a negative trade balance suffers since a portion of its income is directed towards paying for its imports, resulting in a lower income for its domestic businesses. A major reason why countries turn protectionist during crises is that imports are injurious during a time of already falling demand. As a result, the US imposed several trade restrictions on Chinese imports, causing a backlash from the Chinese in the form of similar restrictions placed on the US exports to China. 

    During the Great Depression, similar measures brought on by the Smoot Hawley Act created trade wars, resulting in 50% reduction in both exports and imports, causing net harm to all the countries involved.
    So, even though protectionist measures are counterproductive, a growing negative trade balance is a thorn in the back of the US businesses since it lowers their revenue. As demand falls, the US would want limited imports so most consumption remains restricted to goods and services produced in the US.
    The graph below depicts a rising trade imbalance. The trade imbalance was lower in nominal figures during the 2008 crisis since total income of the country fell, and so did the total consumption of imported goods. However, a trade imbalance remained. This trade imbalance will make the crisis worse, as households begin to hold back on their borrowing and banks restrict their lending.





    The current Greek Fiscal crisis has raised fears of a contagion (spread of the crisis to other regions). These fears are not unfounded and have largely materialized since late April. This has caused large amounts of capital to flow to the safety of the US treasuries, and has raised the value of the US Dollar against that of every other currency in the world.
    The recent bailout announced by the IMF and the EU region is more of a “Shock and Awe” tactic, rather than a long sustainable strategy to help Greece. The underlying problem with bailing out a country, unlike bailing out a company, is that a country can not issue shares, it must issue more debt to pay off previous debt. So that does not lower the debt of the country, but increases it. The problem with Greece is its inability to raise enough tax revenue to lower its debt obligations. In 2009, government expenditures in Greece totaled 50.4 percent of GDP, while the taxes in Greece are too low to allow them to afford such extravagance. Hence, unless the taxes in Greece rise, it is not difficult to foresee a strategic default by Greece of its debt sometime in the future. Also, it is highly unlikely that the EU countries would be willing to bailout a country that is not willing to solve its own problems.
    As the debt crisis in Greece escalates, the fears are likely to spread to the other vulnerable countries in the EU region, namely the other members of the unpopular acronym P.I.I.G.S., Portugal, Italy, Ireland, Greece, Spain. The crisis should then consume the whole EU region and also affect the world economy, in terms of lower lending and borrowing everywhere.


    Conclusion:
    The rising debt of the last 80 years reached a turning point during the 2008 crisis. It has since fallen marginally, and should take another decade or so to decline to its lowest point.  Until then, the economy would see lower economic activity, led by a decline in the desire to consume or invest.
    All investors are encouraged to focus on safety during this time. Safety could mean the traditional bastions such as US treasuries, or other safer bets including small businesses, which have a good business model and regular cash flow, and are independent of the Macro environment.
     


    Disclosure: None
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