Reality Versus Common Sense

Risky assets endured a mini-blood bath yesterday, with major U.S. stock indices down over 2% and Treasury yields down sharply. The 10-year Treasury note yield fell below 3% yesterday for the first time this calendar year. The factors we’ve previously mentioned—China, Europe, Japan, and the U.S. government’s finances—still appear to be the primary ones moving the market, with additional developments in all four occurring yesterday. While our longer-term outlook is decidedly bearish, we think that yesterday’s selloff is more likely to prove a cyclical turn than a secular breaking point. Volumes have been fairly tame through the recent volatility, and credit markets (in the U.S. at least) aren’t yet flashing red. However, we’re certainly getting closer to such an event, and systemic fragility in Europe and possibly China could cause things to unwind rather quickly if risk aversion were to accelerate.

There is a good deal of weaker-than-expected data that seems to be related to the myriad supply chain issues caused by the earthquakes and related damage in Japan. That should be both expected and temporary. The other three factors are the ones that could cause more significant dislocations at some point.  

First, Europe continues to dither with Greece’s external debt problem, even with the shaky dominos of Ireland and Portugal right behind it. Some commentators have observed that if a much larger country such as Spain or Italy were to begin teetering, we’d be in for a look-out-below moment. While that may be true, the fact is that European regulators have been even more lax than their U.S. counterparts in recent decades, with major banks on the continent (notably in France and Germany) levered up well beyond any rational level on assets that eurozone membership conditions and operational realities are now severely undermining the value of. The market price of Greek government debt could eventually be cut in half or worse, but any bank holding it will have suffered a much greater capital loss as a result of leverage, an irony that shouldn’t be overlooked.

In fact, it’s rarely mentioned by those who excoriate the PIIGS governments for fiscal irresponsibility that Europe’s overly privileged banking sector, concentrated in the ‘responsible’ core countries, is the reason that a routine sovereign debt crisis is now capable of causing a global depression (with the help of anachronistic economic policy norms, of course). An ECB member let this fact slip yesterday, noting that a Greek debt restructuring could spell big trouble for some key European banks. No kidding! That realization is probably the main reason that the ECB and IMF have lifted a finger at all, for if the continental payments system were to grind to a halt due to evaporating collateral and sharply rising risk aversion, the world economy would enter another recession rather quickly without concerted policy intervention—something the ECB seems loathe to do, despite the prevailing view of continental Europe as “liberal” (historically, it seems highly unlikely that people left Europe for the U.S. in droves because Europe was too liberal; and the continued existence of monarchies is hardly something we’d associate with either classical or modern liberalism). Despite all of this, the prevailing common sense is that Europe (thanks especially to France and Germany) is “doing the right thing.”   

Second, according to figures released yesterday, growth of China’s industrial economy, while still barely in positive territory, continues to slow. We shouldn’t forget: (1) the country is still working its way out from under a rather significant underemployment problem, the legacy of decades-worth of policy errors under Maoist rule; and (2) social order requires an intermediate-term growth rate that’s well above a sustainable long-term one as it completes its transition to a modern economy. If China is merely hitting a soft patch, which is the common sense assumption, then Asia-Pacific and the global economy should be OK for a bit longer (assuming no shocks to the real economy from Europe or the U.S.). But if there is hidden systemic fragility in China’s financial system, as the FT’s coverage of commodities-as-collateral has pointed to, and/or if looming negative demographic trends in China start to bite, then we could be in for a watch-out-below moment at some point in the not-too-distant future. China’s central government has a relative advantage in moving quickly on macro policy, but that doesn’t mean that it’s free of entrenched interests and resulting distortions (in fact, strong central authority may very well augment this problem), as some aspects of their last stimulus package revealed. If China were to somehow lead the world into recession this time around, currency and exchange rate issues would get really interesting. However it turns out, the prevailing common sense that China is an all-powerful economic juggernaut and America’s largest “creditor” could prove to be rather divorced from reality.   

Ratio of Young Adults to Total Population in China 

Source: U.S. Census Bureau, International Data Base 

Finally, Congress continues to dither with raising the U.S. debt ceiling, primarily as the result of austerity-crusading Tea Partiers who (sincerely, I think) believe that federal government budget deficits are a net-negative for our economy and standard of living. If that were true, I’d be behind them 100%. But it’s not only wrong, it’s downright harmful. Like Clinton-Rubin-Dole-Gingrich in the 1990s, Calvin Coolidge and Herbert Hoover in the late 1920s, and Andrew Jackson 180 years ago, Tea Partiers fail to understand that treating the U.S. government’s finances like an over-leveraged household’s is a sure recipe for recession or even outright depression. But they are not alone. House Speaker Boehner recently released a letter signed by 150 economists, a few of them of the luminary variety (Et tu, Robert Mundell? Vernon Smith?) that claims: “It is critical that any debt limit legislation enacted by Congress include spending cuts and reforms that are greater than the accompanying increase in debt authority being granted to the president.” In other words, they demand austerity now in exchange for a higher debt ceiling, which sort of defeats the purpose of raising it in the first place (I’d love to hear what it is that they think that dry powder should be held in store for).  

Granted, saying that our federal government should be as thrifty as the rest of us just sounds right. But given how our monetary system and financial economy work, it couldn’t be more wrong. And in an economy that is likely to grow at a much slower rate than what we’ve experienced for the last three-plus decades, where households are still over-leveraged and the private sector’s demand for savings is still running well ahead of its demand for credit, it is highly unlikely that the U.S. government will run budget deficits that are too large (i.e., that would begin causing inflation). This is something that people of all political persuasions should be able to agree on, at which point the major parties could begin wrangling over the appropriate combination of spending and tax cuts to maintain a sufficiently large deficit. Unfortunately, we’re nowhere near that point, and we seem likely to impose unnecessary costs on ourselves as a result.

The prevailing common sense on this issue is that federal deficits require debt creation, which will eventually overwhelm the government’s ability to service it. While there’s not enough room here to explain it, that assumption is also wrong, but it naturally gives rise to the belief that we are “stealing” from our children and grandchildren’s futures. Admittedly, there are surely limits (though not of the type widely assumed) on the size of federal deficits and on the level of debt the U.S. can carry. But it looks to us like we’re nowhere near them at this point, and even with the expected entitlement spending associated with baby boomers’ retirement, there’s no serious cause for alarm.

However, the widespread belief that we should be alarmed is leading us to do things today that will have undeniably negative effects on our children and possibly their children. Our local school district’s recently-released budget provides a wonderful example. Its federal funding is set to decline by 28% year-over-year. State funding will decline by 21%. Local tax revenues are expected to increase by 5%. Of those three sectors, only one—the U.S. government—is capable of creating the net new financial assets required to push our economy towards trend growth. The other two are mere users of U.S. money, and the one that’s being asked to make up the difference is already buttressed by higher food and energy prices and looming tax increases. And before the concerted budget austerity that Republicans and a handful of Democrats envision has even gotten off the ground, the federal government has cut its investment in our school district’s children by 28%! That’s an actual burden that our children bear today that will also impose longer-term costs on them (which, for those who believe the federal debt is a problem, certainly won’t help their capacity to service it!); all in the name of slaying an imaginary dragon whose feared effects are decades away.    

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