A Brief primer
The Definition of Economic Progress and how it is linked to productivity has been elucidated in previous posts. Fundamentals. Demand does not drive economic growth; Supply of cheaper/better goods drive growth. Productivity is central to all kinds of progress, when you combine it with Value Creation you have a combination that will deliver sustainable and growing returns.
The key considerations towards understanding the potential return of any kind of asset (Company, Countries, Citizens) is
- the historical record of productivity (People / Performance) and
- the potential to create more value than others. (Product / Economic moat)
Interest is the minimum reward that investors require to incentivize them to save (sacrifice current consumption) and invest in productivity/value creation.
Debt is a great way to borrow from future growth and reduce the hurdle rate (Credit is a side-kick). However when Citizens, Companies and Countries borrow, they do not do it based on future earnings potentials, they do it based on value of assets.
This can create perverse incentives (one of the most common reason for bubbles). The value of an asset is “perceived” – like stocks, real-estate, bonds etc. Borrowing against them is a bad practise. Typically this means money is being fuelled into non-value creating sectors, because the evaluation done by the banks is based on asset values and not on the strength of the investment proposition. A typical example is the lending to home-owners against their homes as collateral , this increases the demand and prices of houses, which in turn channels further capital into this sector (over capacity) , and the lack of future potential earning of the home-owners (sub-prime) led to the subsequent bust in 2008.
If the lending had been based on the earning potential of the debtors, many of the mortgages would never have been created.
Debt Cycles in History
Debt can be taken on by Citizens, Company and Countries. The typical nomenclature is household, corporate and government
The debt cycle begins with one of the actors taking on debt. Households/Corporate could take on debt in large amounts (asset based lending) which become unsustainable. Typically the government steps in to pick up the slack. In other scenarios like war the debt is accumulated directly by the government.
The Nordics – beautiful deleveraging
In Sweden and Finland as a part of financial liberalization, there was a lending boom. As expected in this period of abundance, lending was done based on asset values and not on future earning potential. This created a crisis in 1990’s where the asset prices fell and households/corporate started deleveraging. The government stepped in to ensure that credit did not freeze and took on debt to stimulate economic activity through public expenditure. Once the private deleveraging was complete, the government deleveraged while private sector investment grew, exports grew and inflation eroded some portion of the debt.
The Nordics have been helped by the fact that they were able to leverage global demand for exports, unlike the current scenario where there is a global contraction.
Americas – Financial repression
In America after the Second World War, the government took on significant debt. This debt was eroded over a 35 year long period of “financial repression”. In this the real rates are kept negative for a prolonged period. This ensures that there is a hidden tax on savers (liquidation tax) that is used to bring down the debt.
Debt cycles today
Americas – Repression again?
The UK & US debt woes have a similar start to the Nordic story. Irrational lending practices related to asset based lending, fueled a boom. The household leverage increased significantly, when the future growth (required to pay down debt) did not materialize it resulted in a recession.
The government has stepped in to ensure that economic activity remains propped up. This has created a mountain of public debt (similar to the 2 debt cycles in history).
The good news is that private sector has significantly deleveraged since the crisis. Does this pave the way for private investment and export growth? Probably not! The scenario seems more like financial repression, where the interest rates have been suppressed artificially to ensure inflation can erode debts. However the transmission mechanism for inflation is not as effective. Instead of direct fiscal stimulus, the bulk of the programme is creating new money and injecting this into the economy through banking intermediaries.
QE Mechanism: Create debt –> sell debt to banks –> Use the $ to fund government deficit ($ are injected into the economy) –> Print new money –> buy the debt back –> allow this new money to be injected through the banking sector
As long as the faith in US government debt (T-bills) remains, this should allow the shearing of savers through financial repression over the next few decades. A more violent adjustment would be a loss of faith in US government debt, leading to a sharp rise in interest rates, which would create asset deflation across the board combined with cost based inflation. (Link)
Japan – a severe case of adjustment
Japan again has a very similar beginning to the Nordic story. Private companies took on tremendous amount of leverage (asset based lending). When the asset bubble burst, the companies stopped investing and began to repair their balance sheet. The government has been accumulating debt over a 15 year period to account for this drop in private investment. Refer figure 4.
The argument is that due to crony capitalism, the private sector deleveraging was not quick and took a very long time. In the last 5 years private investment has picked up. Refer figure 5. This is good news, but does this mean that growth will pay for humongous debt accumulated, Probably not!
Abenomics is fighting for inflation. This looks like another case of financial repression in the making. This should be possible as long as faith in Japanese bonds remain, their key advantage is the fact that most of the debt is privately held.
So?
In a world of financial repression, where the savers are going to be taxed (backdoor) to pay for government debts, how would you react.
- A moderate amount of debt to take advantage of negative interest rates (basically shearing other savers)
- Invest in enterprises that have sustained earning potential over and above inflation