A Foray into the Fundamentals of Austerity in Anticipation of the Outcome.

A recent IMF report pointed out some supposed vast amounts of room available for the world’s economies to step up government borrowing to finance consumption, investment and production decisions.   Oddly the report appeared to ignore other forms of debt and material deterioration in key areas of the economic frame.  

When the crisis broke back in 2007 it was clear to me that monetary and fiscal policy would likely need to go for broke to support economic growth and employment at a time of collapsing asset values, debt defaults and a world wide retrenchment in expenditure of all kinds.   As it happened a great deal of that support went into asset prices and financial institutions.

But some years after the crisis, after a slow and drawn out recovery with interest rates locked to the floor, economies still appear to be borderline reliant on debt financed government expenditure.  Any attempt to reduce borrowing, to either raise taxes or cut expenditure to pay back debt would be considered by many to have an adversely negative impact on economic growth, especially at such low growth rates. 

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In the context of interest rate decisions you have to ask yourself just what are we waiting for?

I have seen that the IMF has asked the Fed to defer interest rate increases until we see clear signs of wage increases and inflationary pressure.

The request IMO is both scary and rationale given that so much of today’s National Income Accounting Identity (output=C+I+X-M) relies on factors that lie outside of its operation.  I speak of new bank generated loan growth given that income growth/distribution and investment growth still appear to be weak in the scheme of things..i.e. C+I the drivers. 

The last time the FRB delayed interest rate increases we had a debt financed consumption boom in the US followed by IR increases and a de facto financial collapse.   By raising rates we likely restrict one of the few modes of generating consumption growth in the US (note auto loans) and many other countries.  We also likely raise the impact of existing debt burdens on what are to date still historically low rates of income/wage growth.  

As such you have to ask yourself just what are we waiting for?  Well we need higher income growth, but not just higher income growth: we need a more equitable and fair distribution so that economic growth itself becomes less reliant on debt and low interest rates, and less exposed to the scary divergence of asset values. 

But the world is also changing in ways that question whether we can effectively outwait the inevitable: populations are aging and declining.  Areas where the frame can still expand in consumption terms, areas such as China, may be heading into their own period of slow growth and low IR debt support. 

Importantly will the status quo submit to a reconfiguration of the pie and can the world assume a less debt dependent economic raison d’etre?  

So yes, the rationale to defer interest rate rises is both scary and realistic, but it fails to answer important questions: what are we waiting for, how long can we wait, and are our hopes realistic? 

This is just a quick 3 minute post, but the issues are critical!

Research break & broad comments

I have been doing some research into aging populations, dementia and the care sector over the last 4 to 6 weeks, so I have not been commenting on a lot of economic and market issues.  Needless to say the financial services industry appears in no way prepared to deal with the human issues associated with increasing rates of dementia and service structures in general remain mired in denial.

Economic concerns remain of course the same: weak growth dynamics in the US, world trade growth, China debt and slowing growth dynamics, European structural weakness and the depth of the decline post crisis, significant consumer and sovereign debt, demographics, income and wealth inequality, high market valuations and little margin for leeway in the event of a market or economic shock (interest rates and QE maxed out in most instances).  

Growth risks going forward suggest a negatively skewed distribution of potential GDP growth outcomes and return distributions suggest significant risk of negative returns over fairly long time horizons.  I share many of the same concerns as John Hussman, but my economic growth assumptions for risk management would be below his, indicating a potentially much worse risk outcome for global equity market returns.

It is a moot question whether the investment industry has appropriately modelled risks to return and hence income and capital withdrawal profiles on most portfolios.   Leverage is also of concern, especially in markets with poor regulatory investor protection mandates (note Canada) and I suggest that the time to have reformed the financial industry from transaction to best interests has likely passed for those who have not yet passed through this loop (again Canada). 

One of the reasons I feel that has driven markets forward has been due to increasing income inequality and historically high levels of profits that have pushed marginal allocation of income and profits towards investment assets.  This is a dynamic that will break at some point, either threw an economic/market shock or through its own impact on growth in economic demand.