The Age of Austerity

The S&P500 slipped 0.8% last week on moderate volume.  The VIX (or fear) index also fell as it touched levels not seen in more than a year and a half.  Complacency seems to be setting in, and investors search for clues that will dictate the direction of the equity markets.

Unfortunately, as usual, the fundamental economic data did not support the bullish case.  The U.S. trade deficit widened more than expected, primarily due to the soaring cost of oil.  Retail sales missed badly; they fell 0.3% when they were expected to rise 0.4%.  Initial claims rose more than forecast, and total continuing claims were still near record highs.  Consumer prices increased modestly, as expected.  Corporate earnings season kicked off on a down note–Alcoa missed. 

The equity markets are looking for signs that the one-time cyclical inventory bounce in the second half of 2009 will lead to sustainable organic growth, growth that will not wither away once the government stimulus evaporates.  Given that we are suffering from a balance sheet recession stemming from a financial crisis, such a quick resumption of sustainable growth would be a first in modern economic history.  I’m not holding my breath.

So what happens in an economy that doesn’t bounce back? 

The Economist highlighted a recent McKinsey Global Institute report that examined the ways in which dozens of other countries, with huge ratios of total credit market debt to GDP, deleveraged and the effects of the deleveraging process.

In all cases, countries took one of three paths.  Some defaulted.  Others inflated away their debt.  But in half the cases, nations went through a long period of “belt-tightening, where credit grew more slowly than output”.  And more grimly, the deleveraging actually began two years after the onset of the financial crisis, and it lasted for six to seven years.  In almost every case, economic output fell in the first few years of the deleveraging.

What’s worse in the U.S. today is that the level of debt is higher than the average level in the report.  So the deleveraging will be more painful.  And since so many of the world’s nations are afflicted, the individual nations can’t boost exports to help pay down debt; in the past, other nations were able to boost exports more easily.  Also, today’s debt-laden nations have also hugely expanded public sector borrowing, so that after the private sector winds down its deleveraging, the public sector will need to go through its painful debt reduction process.

And finally, if investors lose confidence in the government debt markets before the private sector completes its deleveraging, then all debt might need to be reduced at the same time.

In every scenario, including the default and inflation cases, the nations that were overlevered suffered a prolonged period of austerity.  After decades of living beyond their means, their tabs had to get paid. Paying down the debts was always painful, and it always lasted about a decade.

This time will be not be different.

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