Debt mountain casts long shadow over growth

SERIOUS MONEY: IT HAS been nothing short of a wild ride in the world's capital markets of late as fears that a double-dip recession is on the way have shaken investors' naturally bullish predisposition.

The optimists discount such concerns and argue that the slowdown in economic momentum is nothing more than a typical mid-cycle pause.

However, whether the developed world double-dips or not misses the point completely; the fact of the matter is that economic growth is not sufficiently strong enough to accommodate the necessary deleveraging of overstretched private and public sector balance sheets, while simultaneously allowing for a reduction in the large and persistent economic slack.

Indeed, most developed economies have yet to surpass the pre-recession peak in economic activity, while private and public sector debt relative to gross domestic product are either close to or at an all-time high. With years of sluggish growth in the offing, it’s hardly surprising that the world’s stock markets exhibit little, if any, upward progress and suffer periodic bouts of painful indigestion. In such a volatile climate, the buy-and-hold mantra that held sway a decade ago is dead.

It all seemed so different to policymakers in the not too distant past, but their hubris in the lead-up to the global financial crisis three years ago was unmistakable. Indeed, back in the year 2000, Gordon Brown, the then British chancellor, confidently declared that there would be no return to boom and bust, as if the Scotsman had somehow single-handedly eradicated the all-too-human characteristics of greed and fear.

Alan Greenspan, the former chairman of the US Federal Reserve, marvelled at the perceived stability later in the decade and argued that financial innovation has “contributed to the development of a more flexible and efficient financial system”. The so-called maestro was oblivious to the fact that the new financial products, which sliced and diced low-quality debt to the nth degree, represented a house of cards that was simply waiting to be blown over.

Even our own Bertie Ahern, the then taoiseach, got in on the act in 2007 and poured scorn on those who talked down the economy. He said that “sitting on the sidelines, cribbing and moaning is a lost opportunity. I don’t know how people who engage in that don’t commit suicide.”

Ahern, like so many others, couldn’t see that the rapid build-up of household debt to fund either conspicuous current consumption or investment in unproductive assets such as housing has never been, nor will be, the road to long-term prosperity.

The accumulation of household debt in the years preceding the crisis was simply staggering. Household leverage in the US, as measured by the ratio of debt to personal disposable income, expanded by more than 40 percentage points to about 130 per cent from 1997 to 2007. In Britain, the ratio jumped by more than 50 percentage points to about 130 per cent over the same period. Meanwhile, household leverage in Spain and Portugal doubled to 110 and 115 per cent respectively.

However, the Irish outdid everyone in the reckless borrowing spree, as the ratio jumped by 85 percentage points to more than 190 per cent.

The growing mountain of private debt went unnoticed by many, as bankers, investors and policymakers were seduced by what appeared to be never-ending tranquillity. Indeed, Gerard Baker of the Times of London wrote at the beginning of 2007: “Welcome to ‘the Great Moderation.’ Historians will marvel at the stability of the era.”

Unfortunately, cracks in the increasingly fragile financial structure were already beginning to appear. And all it took was ripples in a seemingly inconsequential segment of America’s mortgage market to bring the entire edifice to its knees.

The world economy slipped into the most severe recession since the 1930s, and the cyclical deterioration in public finances – alongside bank recapitalisation costs and stimulus packages of unprecedented magnitude – precipitated the sharpest deterioration in public sector balance sheets across the developed world since the second World War.

The data reveals that gross public debt ratios across the G7 jumped from 82 per cent in 2007 to 112 per cent in 2010 and continues to edge ever higher.

More than three years on from the previous business cycle peak and the state of public sector balance sheets across the developed world has caused alarm among the so-called bond market vigilantes and the credit rating agencies alike. Sovereign risk is no longer considered negligible in nations that were traditionally considered risk-free, while the prospect of defaults among the weaker euro zone countries looms large.

Meanwhile, near-zero interest rates and unconventional monetary policies have failed to ignite an economic recovery that is sufficiently robust to result in a fall in aggregate debt levels. Combined private and public sector debt ratios continue to rise in most developed countries, while the extent of the deleveraging in others has been minimal so far.

The private sector’s debt addiction in the developed world in the years leading up to the financial crisis – alongside the subsequent leveraging of public balance sheets to absorb the shock once the crisis struck – means that the world’s major economic centres face years of subdued growth, as previous excesses are unwound.

The real question facing investors today is not whether the western world will double-dip, but whether the “Great Recession” ever really ended. The secular bear market in stocks rolls on.

www.charliefell.com