As it came to pieces in my hands…

Paul Weller: “I stood as tall as a mountain; I never really thought about the drop; I trod over rocks to get there; Just so I could stand on top; Clumsy and blind I stumbled;…I didn’t stop to think about the consequences; As it came to pieces in my hands.”

The 2008 crisis told us that there was a mismatch between asset values and debt, asset values and future return, and debt and economic growth as well as some rather large structural economic imbalances.

We have tried to delay the eventuality implied by the difference in the hope that the “true” magical economic growth rate should return. Have we built up a bigger monster, and if so, how do we slay the beast?

You definitely get the impression that the QE generated facade of recovery and asset price “regained omnipotence” has hit a brick wall in the last few days.  Japanese and global equity markets had gone off on a tear in the last week in response to BoJ QE plans, but equities are falling back heavily and key commodities are in free-fall.  

Europe has not been getting any better, and sovereign debt and banking sector worries have resurfaced with Cyprus and renewed concerns over the worsening situation in Portugal for starters. 

We now have whispers of wealth taxes, confirmation of bail ins as de facto templates for bank recapitalisation and enforced gold sales for European debt ravaged sovereigns.  The trouble is now that it will not take signs of a recovery, but the impact of a long and sustained recovery to right the European ship: a drowning man needs to get back to the surface, not merely bounce off the river bed!

In the US, economic activity has slowed measurably across a broad range of indicators, and now Chinese data shows an unwelcome slowing of growth. 

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Perhaps many forgot that we lie in a low growth era, with significant lower bound risks.   These risks have been expanding in Europe, but with weakening US indicators, the US economy is indeed getting closer to the lower bound.  Slow growth is insufficient to a) lower unemployment, b) raise government revenues, c)generate necessary capital investment, d) sustain the property market revival and caps consumer expenditure plans and expectations.  Also, the lower the returns the lower the future value of all debt and the greater the impact of any fiscal cutbacks.

Arguably QE has much greater benefit when both the economy and the markets are moving forward.  This is not a good sign!

China growth, recently refuelled by credit growth after a 2012 dip, seems unable to generate the organic return required to keep their asset and liability balance sheet stable.  

The price of an asset can be determined by discounting its future cash flows.  When the pricing relationship is bounded primarily by demand, with supply growing in line with fundamental demand, it is easy to see the lower discount rate: while the price may be wrong, the asset still has a viability. 

But when supply is expanded well beyond the ability of the economy to absorb within its operating capacity, and prices are supported by demand, the return per unit of capital creates a real price that is below the current price: the price and the supply are both wrong, with supply impacting the viability of operating assets.   

The risk with too much capital investment in developing economies is not that excess capacity is built up (you need to grow into your clothes), but that too much excess capacity is built up and the margin becomes an increasingly destabilising one.  At a certain point in time, the required margin between current and necessary future capital should stabilise and the amount of capital investment likewise.  Growth in gross fixed capital investment needs to start decline to reach a steady state.  Too much credit fuelled growth in capital formation puts the financial system and economy at much greater risk, especially so if credit fuelled capital investment is the major component of growth.   

Have we reached the end of our ability to stimulate demand through quantitative easing in some countries and government supported credit growth in others?

The 2008 crisis told us that there was a mismatch between asset values and debt, asset values and future return, and debt and economic growth as well as some rather large structural economic imbalances. 

We have tried to delay the eventuality implied by the difference in the hope that the “true” magical economic growth rate should return.  Have we  built up a bigger monster, and if so, how do we slay the beast?   Some would suggest Central Banks should forgive the debt they hold, which they could, but this would release a final reiteration without affecting many of the crippling structural imbalances.   Raiding the assets of the rich may do it, as the 5 wise men have suggested, but it will be ugly and, of course, how far down into the pit do we go before this becomes reality?

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