Economic Commentary: Skirmishes In A Currency War?

Global Economy Probably Weakening

A downward trend in leading global indicators, manufacturing, and trade has many central banks and political leaders concerned, and they are collectively doing a number of things to try to keep growth on track.  Quantitative Easing (money printing) is very widespread, as are currency interventions and stimulus spending.  By some measures the world has recently fallen into a global recession, with 45% of the OECD’s 41 countries already having recorded two consecutive quarters of negative GDP growth.[i]  Even the economists at Goldman Sachs say they think a global slowdown phase lies just ahead.[ii]  In the USA, preliminary GDP growth was reported as +0.1% for 4Q/2012,[iii] YOY growth in durable goods orders has fallen to zero,[iv] and the Chicago Fed’s National Activity Index for January was -0.32, indicating US economic activity remains sluggish.  The Philadelphia Fed’s January Business Outlook for manufacturing recorded a -12.5 reading, the second in a row, but recent national housing data have been much better (at least on on paper), with monthly new home sales soaring over 15% (annualized) in January.[v]  (However, note that this increase was based on a calculated 437,000 home annualized rate of sales, which was adjusted for seasonal effects off a mere 31,000 raw, or unadjusted actual sales.  Thus 406,000 or 93% of the total reported sales are tenuously supported adjustments to the raw data).[vi] 

Durable goods orders excluding transportation equipment climbed in January the most in a year, suggesting growing demand and a continued recovery.[vii]  So the signals are still mixed in the US, and hope remains that somehow we will avoid the global trend.  However, the debt ceiling/sequester crisis in March will probably hurt both the US economy and the markets to some degree, perhaps causing a 0.5% reduction in GDP.  When this reduction to already sluggish GDP is combined with rising fuel prices and higher payroll taxes, which will be  cutting a wide gash in consumer spending in the months ahead, it would not be much of a stretch to end up with stagnant growth or even a mild recession.  This certainly indicates downside risk to Wall Street’s projections of continued economic growth.

Debt, the Credit Cycle, and Economic Growth

Many countries are simultaneously deleveraging their private sectors while boosting overall debt, due to government deficit spending.  Enormous central bank asset purchases (QE, or money printing) have kept the bond vigilantes at bay so far in most countries (except in Europe), but one aspect of this deserves more attention than it gets: the fact that these spending patterns and excessive debt are slowly killing economic growth.[viii]  Carmen Reinhart and Kenneth Rogoff have shown that once a country has exceeded a 90% debt/GDP ratio, economic growth has historically been reduced by 2% per year for a period of about one decade, on average.[ix]  By their metrics, the US already has a debt/GDP ratio of 100%, which may explain the really sluggish growth we’ve observed in the last two years. 

Why does a high level of debt tend to dramatically slow down growth?  Because when debt is high, capital is being misallocated to non-productive purposes, such as financial engineering, market speculation, corporate rent-seeking behavior, debt service, and unfunded government handouts. [x]   Over time, less and less is invested in income generating assets such as capital equipment, buildings, toll roads, etc., and so future GDP growth and national net worth suffer.  By not investing for the future, corporations and governments are simply hoping for a future rather than planning on one.  History shows that this doesn’t work in the long run, and since we started down this path many decades ago, we are now facing the long run’s consequences.  Jeremy Grantham of GMO thinks that as a result, we are now facing decades of low GDP growth (averaging around 1.4% annually, or half the normal rate).  Grantham also believes that there is a low or negative correlation between stocks and GDP, so it is unnecessary for investors to worry about some kind of permanent decline in stocks, and indeed plenty of money can be made in the markets.[xi] 

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