Still Pending: the 'great correction'
Is this really the “great correction” that we think it is?
For more than a year, the “recovery” bounce in the stock market has refused to give up. The indexes have recovered more than 50% of what was lost. Technically, they look pretty good. What’s more, the S&P sells at more than 21 times normalized earnings, according to Robert Shiller’s latest tally. It seems like nothing can stop stocks now.
Then there’s the Treasury market. Overall, yields remain remarkably low. It is almost as if Treasury buyers are unaware that they are being asked to finance the biggest increase in sovereign debt ever. It doesn’t seem to matter either that many of the applicants for money will be incapable of repaying it. Several sovereign debtors, including the US, have already reached the “point of no return,” according to professors Rogoff and Reinhard.
Still, the financial press is optimistic. Economists are irrationally confident. Investors and advisors are overwhelmingly bullish. And the American public seems willing to add a trillion-dollar health-care program to its burdens – a sign of remarkable faith in the nation’s prospects.
So, let’s go back and reexamine our basic position. Is this really the “Great Correction” that we think it is?
If there is one lesson we’ve learned over the years, it is that we need to be patient. Things that have to happen generally do, sooner or later. You just have to wait. And when they happen, they generally happen much faster than you expected. Even when you’ve been expecting something for years, it can come and go before you realize what is going on.
You get used to being wrong…or at least premature. You wait. You watch. You think the time has come…and then: whoops…not yet. Pretty soon, you are overcome by anticipation fatigue. Then when the real thing finally does start to happen you don’t believe it. You wait to be sure…you hesitate…and then it’s over!
Just what am I waiting for? I’m anticipating more evidence of this Great Correction, including another big swing down in the real price of stocks, bonds and commodities…further deterioration in the real estate market…a falloff in consumer spending…and a higher savings rate.
I’m also expecting higher yields from government debt…and a dangerous intensification of financial problems in both the private and public sectors. If I’m right, those things must happen eventually. So far, we’re still waiting.
But this week the long-awaited turnaround in the bond market may have begun. Rates are rising along the entire yield curve, especially at the long end. “The bond market is now very close to saying, ‘We’ve had enough,’” predicts the octogenarian stock market technician, Richard Russell. The 30-year T-bond’s recent decisive move above 4.80% marks the end of a 25-year bull market in bonds, says Russell. Rates will be moving higher from here.
Investors are starting to tune into how sovereign debt works. And they’re starting to realize that even governments can default. In fact, almost all of them do default eventually. Yes, even governments whose debts are denominated in their own currencies default. And even when they have the power to print the currency themselves.
How could that be? Well, it is very simple and worth spending a little time on. I want to make two points:
First, governments will usually choose to default on their debt rather than risk hyperinflation of their currencies. Second, when they reach a “point of no return” they have no choice. They cannot cut back spending. Because even the most drastic cutbacks will not do the job. That would simply result in lower tax receipts and an even bigger deficit. At a certain point, the multiplier effect becomes the divider effect.
I’ve made the point many times that democracy seems hell-bent on self-destruction. America’s founding fathers noticed many years ago that when people realized that they could vote themselves money from the public treasury, democracy would be doomed.
Most people presume that if a politician offers benefits, “someone else” will pay for it somehow, someday. In practice, the money doesn’t come from additional taxes. Taxes are already, at least theoretically, at their optimal level. Higher tax rates produce lower economic activity, which lowers tax receipts. So instead of raising taxes, governments borrow the money. Then sovereign debt loads become larger and larger until, as Greece has recently discovered, they are impossible to carry.
America also has public sector debt problems – of about equal measure to Europe – and she has huge private sector debt problems as well. For the moment, the skies over the American financial markets are clear. But out at sea a hurricane is spinning faster and faster. There is a huge wave of debt defaults/foreclosures in the private sector that will hit the markets soon. This wave, combined with record borrowing from the US government, is bound to push up bond yields…making it harder than ever to get needed funding.
The situation with the US government is more complicated than it is with private borrowers – or even with Greece or California. The federal government can print money. But it, too, is ultimately at the mercy of the bond market. Last year Uncle Sam borrowed $2.1 trillion. This year it will borrow $2.4 trillion. Without this money, US government spending would have to come to a halt. The US counts on lenders. It needs lenders. Without them it would be forced to make cuts equal to about 10% of GDP. Think you’ve got de-leveraging now? Just imagine what that would do.
Typically, of course, government bond buyers don’t cut off a lender altogether. They merely demand a higher rate of interest to offset what they see as an increased level of risk. The higher interest rate adds to the borrower’s cost – increasing his deficit and forcing him to borrow more.
This is where it gets interesting. You might say that a government can “print its way out” – it can just print the money it needs rather than borrowing it. But what would happen if the US chose to print $2 trillion this year? It would risk hyperinflation. Lenders would run for cover. Prices would shoot up. The damage to the economy would be severe…so severe that only governments under extreme pressure – think Weimar Germany or Mugabe’s Zimbabwe – are willing to risk it. Instead, they try to muddle through, as Greece is doing now – promising budget cuts, making special financing deals and pushing up the rate of inflation a bit, but not so high as to cause panic in the bond market.
See, as long as the bond market permits it, debt levels continue to grow. But at some point – the point of no return – a government can no longer save itself from disaster. How does that work? Well, when deficit/debt levels are too high, the cuts necessary to bring the budget back in balance are so great that they squeeze the economy hard, reducing output and decreasing government’s tax revenues.
In this case, the government cannot escape. It has to print money. Or default. Most often, it will choose default, because it is the less painful solution. Either way, the government finds that it will be cut off from the bond market. Hyperinflation is merely an additional and unnecessary aggravation. (That said, I agree with Nassim Taleb, that hyperinflation remains an underestimated black swan risk.)
The underlying story of the economy has not changed. We are in a Great Correction. We don’t know exactly what it is correcting…but it looks as though it will at least reduce some of the leverage that has been added to American and British households over the last 60 years.
So far, the process is tentative…and unsure of itself. From a peak of 96% of household income in 2007 debt has fallen to…94%! The drop is so small that it makes you wonder if it is a trend at all. But if it is, it has a long way to go. Ten years ago – at the peak of the dot-com bubble – household leverage was only 70% of income. At the present rate it will take another 24 years to get back to 1999 levels.
Albert Edwards of Societe General has examined the non-financial leverage in the system. There is excess leverage of about 60% of GDP, he says. He calculates it will take a decade of “Japan-like pain” to eliminate it.
Either way, you’re talking about a long process of getting back to “normal.”
The Great Correction is also what is keeping housing and unemployment down. When the banks aren’t adding to the nation’s credit, you just can’t expect many new jobs or many new house sales.
Nothing has changed in the last week – except we have moved one week closer to whatever crisis lies ahead.
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