It’s The Debt, Stupid

June 7, 2010
By

Flash back to 1992: Bill Clinton versus Bush 41. One of the memorable phrases from Clinton’s winning presidential campaign was “It’s the economy, stupid.

Updated for 2010 one could say: “It’s the debt, stupid.

As sovereign nations max out their collective credit cards, there are real questions as to how much stimulus ammunition is left… and thus what comes next for the global economy.

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Bloomberg has an unsettling story out, U.S.’s $13 trillion debt poised to overtake GDP.

Check out the embedded chart:

The red line is U.S. income (GDP) and the blue line is U.S. government debt. Sort of like in Ghostbusters, you do NOT want to see those streams cross with the blue line (debt) headed to the upside.

This is because of frightening historical precedent. Two economists, Ken Rogoff and Carmen Reinhart, did a truckload of deep-dive research on debt levels and crisis throughout the ages. What they found is that, when a country’s debt level surpasses 90% of GDP — right about where the U.S. stands now – that creates a powerful drag on economic growth.

A heavy burden of government debt tends to “crowd out” other forms of investment. In times of economic weakness, big banks and cautious investors show a tendency to park their cash with Uncle Sam rather than putting it in play, which slows the economy further. And of course, the government is an absolutely terrible allocator of capital.

Right now, crisis fears are far more centered on Europe than the United States, to the degree that U.S. Treasuries have been a go-to safe haven alongside gold. But escalating levels of U.S. debt are a reminder that virtually ALL western nations are deep in the muck.

And if the western world is stuck in debt quicksand, that’s bad news for up and comers like China too. If China finds its biggest export markets (Japan, Europe and the U.S.) slowing down and tapping out, the dragon further finds itself unable to sustain domestic growth — and worse still, exposed to huge overcapacity via jumbo infrastructure investments. (Think highways no one drives on, ports sitting idle, factories and airports empty…)

No More Stimulus

At the same time that investors’ minds are being concentrated on sovereign debt issues, leaders of the G20 nations are uniting in their commitment to ‘no more stimulus.’ This is more unsettling news for liquidity-dependent equity markets.

From the FT:

Finance ministers of the world’s leading economies have been so spooked by the sovereign debt crisis that they have decided they can no longer wait until economies are growing strongly before they remove fiscal stimulus…

The communiqué of the meeting made clear the G20 no longer thought expansionary fiscal policy was sustainable or effective in fostering recovery because investors were no longer confident about some countries’ public finances…

- FT, G20 drops support for fiscal stimulus

So now we see another major reason for investors to fret. The political will for more stimulus has faded away to almost nothing (due to a newly concentrated focus on ‘austerity’ measures to cut back debt). And so, if the global economy stumbles again, the odds of a follow up “all-in” style bailout are low.

The First Shot of Stimulus is Wearing Off

A debt crisis is a funny thing. It’s one of those elements that “doesn’t matter until it does.” Investors might be in a frame of mind to ignore mounting debt levels for a long, long time — to treat the subject with indifference.

But then, all of a sudden, there is a paradigm shift. What doesn’t matter suddenly does matter — a lot — and then the snowball effects and domino chains kick in.

So now we have two harsh dynamics in play, followed up by a third:

  • As of now, excessive sovereign debt levels “matter” again.
  • G20 leaders are committed to “no more stimulus” so they can cut back debt.
  • The original stimulus shot is starting to wear off.

No matter how you slice it, that’s a damned ugly trifecta for stocks.


Austrian Econ 101

Much of Austrian economics is centered around the concept of the boom-bust cycle. The boom-bust cycle is created by government attempts to prevent recession — to artificially remove the down parts of the cycle — by letting the money flow and juicing credit.

This artificial juicing works great for a while, but the problem is the massive overhang of debt that occurs. Whereas a “normal” recession would reset debt levels and clear out leverage to a healthy degree, government intervention means debt and leverage levels just pile up higher and higher, until they reach dangerous extremes.

Over time, all that debt and leverage becomes like a giant tower of Jenga blocks. There’s no way to get rid of it, and even the slightest breeze of economic downturn threatens to topple it. The global financial crisis of 2008 was tackled by making huge transfers of private debt onto PUBLIC (i.e. government) balance sheets… and now those balance sheets are teetering.

So, here’s my rough assessment of where markets stand as of now:

  • In response to the 2008 meltdown, governments went “all in”.
  • That stimulus created a huge boost for paper assets.
  • It also created a modest boost for the real U.S. economy.
  • After a year  or so of euphoria, though, the stimulus is wearing off.
  • And debt-burdened G20 governments are saying “no more.”
  • There is little political will for further mass stimulus…
  • …and a strong chance that the stimulus boost will fade.
  • The markets are now adjusting to a paradigm shift from “priced for perfection” to “tough times ahead.”

When functioning properly, markets are supposed to be a forward discounting mechanism. Prices today should reflect the outlook down the road.

And right now that forward market outlook says, “Oh crap — what happens if the last 12 months of growth were mostly a stimulus-driven mirage… our problems run much deeper than we thought… and there are no more bullets in the gun (or political will to fire the gun) if the economy starts to tank.”

JS

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