Australia | Sep 03 2010
By Greg Peel
There have been four recessions in the US over the past thirty years – 1982, 1991, 2002 and 2008. Two years after the 1982 recession, nominal US GDP had bounced back by 15.5%. After 1991 the recovery in the same time frame was 9.2% and after 2002, 6.9%. Is there a trend here?
Unfortunately, yes. We are now nearly two years out from Lehman Bros and the 2008 recession but the US economy has grown by a paltry 0.78%.
It is this number which is critical to the suggestion from leading US fund manager BlackRock that the US economy is likely on its way back into recession (as measured by two consecutive quarters of negative GDP growth), which will prompt an inevitable policy response of renewed fiscal and monetary stimulus. The Fed will need to re-implement quantitative easing (QE2), says BlackRock, in order to unlock the vast amounts of cash on corporate and bank balance sheets to grow real GDP alongside inflation.
FNArena was yesterday invited to attend a presentation by Tom Callan, US-based managing director of the BlackRock's US$12bn Global Opportunities team.
It is not difficult to ascertain just why this time there has not been any sort of meaningful bounce out of recession. The following graph provides a clue:
Clearly the Great Depression saw an unprecedented spike in US total debt as a proportion of GDP as GDP growth collapsed. Not until the US government made the right policy decisions did debt become inflated away. Thereafter followed the consumer boom times of the post-war period, culminating in double-digit inflation during the oil-shocked seventies. It was in the seventies that President Nixon removed the gold standard on the reserve currency which, as the graph indicates, let slip the dogs of uncontrolled borrowing against a supposedly all powerful US economy.
By 2003, US debt to GDP had regained the levels of the Great Depression. By 2004, Fed chairman Alan Greenspan had (he now admits erroneously) reduced the cash rate to 1% in response to the tech-wreck and 9/11. Debt growth continued unhindered, and imported disinflation from the low-wage Chinese manufacturing sector provided a false mask over the bubble that was forming.
The rest, as they say, is history. The US government and Federal Reserve threw all it could at the economy by way of fiscal and monetary stimulus in response to the GFC, but is now clear this only provided for a false dawn. US banks and corporations have moved to reduce leverage and have raised extensive amounts of fresh capital while cutting dividend payments. The result is enormous amounts of cash now sitting on balance sheets. The problem is no one is game enough to use it. In a world of global uncertainty and the deflationary impact of ongoing deleveraging right down to the household level, cash is king.
The Fed's cash rate is effectively zero, but this has not encouraged banks to lend or corporations to invest in growth. As a result, unemployment remains stuck at high levels. Mortgage foreclosures continue to increase, and small banks continue to go out backwards. Without the support of the US consumer who provides for 75% of GDP, banks and corporations remain unwilling to take on risk. For an economy to grow, cash needs to move around the system, passing from bank to corporation to employee to retailer to supplier to producer and round and round we go. If cash merely sits in the vault gathering dust, the economy grinds to a halt. That is what appears to be happening at present. And the following two graphs provide evidence of just how much dust is gathering:
As US economic data continue to paint a weaker and weaker picture, it is clear that the economy is now missing its earlier fiscal stimulus. The Fed is maintaining its level of quantitative easing by reinvesting maturing assets, but treading water is not enough. Neither the government nor the Fed can simply appeal to banks and corporations to lend/spend money in this environment and expect some sort of patriotic response. More direct action is needed. Says BlackRock, as previously noted:
“Coordinated monetary and fiscal policy could help unlock cash on corporate and bank balance sheets to grow real GDP alongside inflation”.
The most obvious policy measure for the government is tax incentives – the sort of supply-side response that was the feature of the “Reaganomics” period which helped drag the US out of the stagflated seventies. Unfortunately such a measure is anathema to Democrat ideology and in contrast to Obama's election platform. But with the mid-term elections looming and his popularity rating slipping precipitously, Obama may be left with no choice. For Main Street it's all about three things – jobs, jobs and jobs.
As far as the Fed is concerned, Ben Bernanke has already outlined at least three monetary policy options which can be implemented were the US economic environment to “deteriorate appreciably”. The Fed can return to buying mortgage securities rather than letting them mature off the books, and it can return to monetising Treasury debt by buying Treasury bonds with printed money. But perhaps the obvious first step is the third option.
Currently the Fed is paying banks 0.25% interest on cash lodged with the central bank by commercial banks. While this policy was originally introduced to encourage banks to rebuild cash it is now working as a disincentive to putting that cash “to work” in the economy through asset building, which simply means lending. Bernanke has suggested that he will drop the Fed deposit rate to zero if the situation warranted.
But Bernanke has also dropped clanging hints that monetary policy alone may still be impotent without coordinated fiscal stimulus. No doubt behind the scenes, Bernanke has been chewing off Tim Geithner's ear. But not all of the members of the Federal Open Market Committee nor all of the Fed regional presidents support QE2 in fear of simply fuelling another asset bubble. There is dissent in the ranks, which is likely why Bernanke has not acted already.
As Tom Callan noted in his presentation, Fed newbie Bernanke outlined in 2003 his suggested policy measures to drag Japan out of its destructive decade of deflation. His proposals included tax cuts for households and businesses coupled with incremental bank purchases of government debt and commitment to reflate the economy. Such measures would increase household wealth, Bernanke intoned, and lift spending.
The US is currently facing down the barrel of its own decade of deflation. Comparisons with Japan are being made every day. Noted Callan:
“Today, policies that aim to change consumption and investment psychology from a belief that cash will become more valuable in the future [deflation] to a belief that it will become less valuable [inflation] might help to mobilise liquidity. An artificially high explicit inflation target could be quite effective in this regard”.
Bernanke is also well known for a 2002 presentation in which he suggested the US possesses the most powerful policy tool on earth – the printing press – which can be used with impunity. There is no simpler inflationary tool than the increased supply of money.
It is BlackRock's belief US authorities are now facing little choice but to fire up the presses once more. Emerging economies pay be growing comfortably but the US economy is stagnating. And while the European economy has been boosted recently by a weaker euro encouraging increased German exports, growth in Europe remains otherwise anaemic and the region continues to face its own debt challenges.
If BlackRock's predictions prove accurate, how should an investor on the other side of the world react?
“We remain confident about the sustainability of growth in the emerging economies of the world,” suggested Australian-based BlackRock investment specialist James Holt, “given low levels of consumer leverage in those countries, and this bodes well for Australia in general.”
“However, precisely how the world’s biggest economy chooses to escape massive indebtedness, and potential debt deflation, has big implications for investors around the world. If the US elects to inflate away much of its debt, investors will need to careful that they are not unwitting victims of money illusion and unanticipated capital losses if they invest in cash and bond markets, which would be adversely affected by rising inflation after decades of dormancy,” Mr Holt said.
In other words, if the QE2 sets sail, don't find yourself stranded on the dock.
