A Vicious Circle of Debt Deleveraging and Recession

September 30, 2011

A dangerous storm is brewing, and at its core is reinforcing debt and weak growth that can be found in advanced economies.  Just over two years ago, these nations emerged from their worst business downturn since the 1930s.  From peak to trough, real GDP fell 9.9% in Japan, almost 7% in Great Britain, and marginally over 5% in the United States and euro area.  The Great Recession propelled excessive debt levels to substantially greater heights.  The simultaneous effort now by consumers, governments, and banks to restore sustainable debt levels is keeping economic growth too low for those attempts to succeed.

A way to break out of this self-perpetuating maelstrom is being hampered by five additional factors.  First, the move to a common European currency was a very bad idea to start and made even worse by an inflexible design that omits a centralized fiscal policy or an exit strategy for unworthy members.  Like bank loan securitization, the so-called economic and monetary union created a false illusion of minimal risk that promoted a pyramid of interlocking financial obligations, and such grew very large before the depth of risk was understood.  Second, Japan’s trifecta of natural disasters in March shook Japan and economies that depend on Japanese-made supplies at a time when their recoveries were too fragile to absorb such a blow.

Third, western democracies have been corrupted by money politics.  Elected governments in the United States, Europe, and Japan no longer seem capable of solving any of a myriad of problems that threaten to upend life as we know it.  Most of the corruption is institutional and breaks no laws.  But voters have lost confidence that in-system solutions will emerge from the public sector.  Fourth, the credibility of the private sector to self-govern and heal itself has been badly damaged, too.  Private enterprise depends on market mechanisms, whose extremely erratic daily behavior is encouraging an exodus from risky assets and leaving businesses too gun-shy to commit liquid resources to investments that could promote growth in GDP and jobs.   The fifth problem is a lack of institutional memory, enabling many of the same mistakes made in the early 1930s to be repeated on both sides of the Atlantic.  Restrictive short-term fiscal policy, for example, is an unproductive way to cut debt.

Advanced economies seem to be nearing a rendezvous with another recession.  Growth momentum has been slip-sliding away for the past five quarters.  The table below expresses GDP annualized growth (% per annum) in the United States, Great Britain, Japan and the euro area over the three quarters through 1Q11 and then during the second quarter of this year.  This past summer, conditions turned more ominous.  The German Dax plunged about 26%, and the S&P 500, British Ftse and Japanese Nikkei dropped somewhat more than 12%.  Ten-year Treasury and German bund yields slumped over a whole percentage points from more than 3.0% to less than 2.0%.  The Japanese and Euroland purchasing manager indices for manufacturing and services are now below 50, signaling contraction.  Overall economic sentiment in the euro area weakened from a reading of 105.4 at midyear to 95.0 in September.

GDP Growth, % pa U.S. Euroland Britain Japan
1Q11 vs 2Q10 1.7% 1.1% 0.0% -0.7%
2Q11 vs 1Q11 1.3% 0.6% 0.7% -2.1%


2011 isn’t 2008, and I mean that in an unfavorable way.  A cohesive response of economic policy to the Great Recession didn’t prevent it from being the most severe downturn in 70 years but did manage to shorten the length and prevent the recession from evolving into depression as happened in 1930-31.  Key emerging markets like China and India aren’t now predisposed to massive stimulus because, unlike then, they are experiencing unacceptable inflationary pressure.  Fiscal reflation is not politically feasible in the United States or Europe, even where scope exists as in Germany.  Monetary options are much more limited in number now, and the tools that remain are not as powerful as the menu selected three years ago. 

Many economies have become less competitive.  Unemployment remains extremely elevated, and the social safety net has been torn by depleted resources.  When economic activity is shocked into a phase of contraction, the business cycle tends to acquire a certain amount of self-feeding momentum, which is hard to break without some policy assistance.  Japan must contend with yen appreciation since mid-2007 of roughly 60% against both the dollar and euro and of 34% against the yuan.  Other economies carry different individual burdens.  All things considered, I’m not persuaded by the conventional wisdom that a second leg of recession cannot possibly be severe or long-lasting because the last one cut excesses to the bone, and pent-up demand cannot be delayed indefinitely. 

From the standpoint of willingness to take a risk, a stronger case can be made for the glass being more than half empty and likely to stay that way.  At such extreme times, the dollar rises as in late 2008-early 2009 and recently.  An upward run likely will continue.  Commodity-sensitive currencies remain especially vulnerable, as do currencies like sterling that have habitual large current account deficits. 

The euro faces conflicting possibilities, since a Greek default is perhaps less than a month away.  Amid fear of contagion to other EMU peripherals, a Greek default might push the common currency beyond $1.30, but a sell-the-rumor-buy-the-fact reaction is also possible.  There will be relief getting the timing of this inevitable event out of the way, and a default will be followed by all sorts of rumors concerning the exposure of different banks to Greece.  It’s not just European lenders.  Big U.S. institutions will land on that list as well, and that could weigh on the dollar.

Copyright 2011, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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