A Vicious Cycle: Part I

247Bull.com Editor: In his latest Amphora Report, John Butler tackles one of the most important macro trends we see. I.e., the huge wealth transfer which is already taking place thanks to the actions of reckless central bankers. As John points out, While a printing press can’t create wealth, over time it can transfer it from those who don’t have access to the press, to those who do”. Every investor, and anyone with wealth, should be deeply concerned about this trend. For further reading on how to protect yourself from what we believe will be the greatest wealth transfer in history, see: The single best reason to own gold, and How to profit from QE3 & the coming wave of liquidity, and Why today’s system of fiat money is doomed to fail & what it means for investors.

Economic data the world over indicate that a global economic slowdown is well underway. Central banks have already responded with fresh stimulus, as anticipated by financial markets. But just as the economic recovery of 2009-2011 was largely artificial and, thus, disappointing in key respects, so the unfolding slowdown is going to result in a few nasty surprises. In this Amphora Report I discuss what I believe to be some of the more important implications of the current, ‘vicious’ cycle, in which unseen damage is being done to the global economy. As the damage becomes apparent—perhaps already this year—equity market valuations are going to take a hit.

Not your parents’ business cycle

For some months now, leading indicators the world over have been pointing toward slower growth ahead. It’s not just about the euro-area any more. China, India, Brazil, the US, Japan—most economies appear to be slowing. A major recession may not be on the way but below-trend growth has already arrived and looks set to continue into 2013. Business cycles being a fact of economic life, the current slowdown is not surprising in of itself. No, what is surprising is the upturn that preceded it. By various measures, it was deeply disappointing.

First, in the developed economies, the level of real GDP has yet to materially exceed the previous peak reached in 2007. For a downturn to begin without having exceeded a previous output peak is one way to distinguish a ‘depression’ from a ‘recession’, a semantic point discussed in a previous Amphora Report, From Deflation Push to Inflation Shove (June 2012; The link is here.).

Second, while headline growth has been disappointing, the mix of growth has also been poor, that is, it has been driven somewhat less by real fixed investment and final demand, and rather more by stimulus-fueled inventory accumulation. Indeed, in the US, real final demand, considered to be the ‘core’ rate of GDP growth, has struggled to rise above 2% y/y, far below the level seen in past recoveries.

A sub-par recovery: weak final demand

A sub-par recovery: weak final demand

Now inventory accumulation is not necessarily a problem. There is nothing wrong in principle with producing today that which will be consumed next year. But businesses must remain confident that the inventory will indeed be consumed at some point and won’t cost too much to finance in the interim. Lose that confidence and businesses will seek to reduce inventory, with all the negative implications for jobs, incomes and growth generally.

Now why might businesses be concerned that inventories are too high? Well, in the US, the inventory to sales ratio has been creeping higher, albeit from a low level. More worrying, personal disposable income growth is weak, in part due to the large decline in the workforce participation rate over the past three years.1 And, notwithstanding a small rise in the household savings rate since 2009, households have yet to meaningfully de-leverage. Indeed, the truth is rather the opposite, as household net worth has plummeted as a result of the housing market crash. There is thus little if any so-called ‘pent-up demand’ to absorb accumulating inventory.

US homeowners’ equity has yet to recover meaningfully from the crash

(Equity as % of real estate assets by market value)

US homeowners’ equity has yet to recover meaningfully from the crash

Source: Federal Reserve

Corporations may look in comparably better shape. Profit margins are elevated. They have accumulated much cash on their balance sheets in recent years. But as I have pointed out before, they remain unusually highly leveraged in a historical comparsion.2 The aggregate corporate debt/net worth ratio, at nearly 70%, is much higher than is normally associated with high rates of fixed investment. No, corporate investment is not going to lead the way out from here. As is the case with households, there needs to be an economic de-leveraging first. This is a simple, unavoidable economic fact, policymaker rhetoric to the contrary notwithstanding.

The trick thus becomes how to engineer this de-leveraging. Central banks are resisting a natural, deflationary de-leveraging in which prices decline to levels that clear the excess inventory and excess capacity in various sectors of the economy. (By ‘excess’, I mean that which has run ahead of underlying real income growth and net savings.) This resistance follows directly from their stated aim of rescuing their weak financial systems, still drowning in distressed, illiquid assets.

Preferable from their point of view is to engineer an artificial, policy-driven reflation instead, as this will erode the real debt burden and keep the financial system more or less intact as is. Eventually, so the thinking goes, through inflation, incomes will rise to levels that can service the accumulated debt such that healthy, sustainable growth can resume.

Perhaps central bankers can pull this off, although putting fresh capital in the hands of those who misallocated it in the past doesn’t exactly come across as a compelling long-term growth strategy. It is as if a failing corporation (USA Inc), rather than firing underperforming managers (Wall St), gave them large bonuses instead (TARP). Who in their right mind would invest in such a firm? When it becomes a national policy, who in their right mind would invest in such a country?

In any case, what policymakers won’t tell you is that this sort of artificial reflation is a wealth transfer from the real, productive economy to distressed, in some cases politically-connected firms that receive first access to the new money entering the economy. This is important. While a printing press can’t create wealth, over time it can transfer it from those who don’t have access to the press, to those who do. Indeed, if printing presses actually created wealth and distributed this evenly and fairly throughout society, why on earth would counterfeiting be illegal?3

1 At only 63.5%, the labour market participation rate has declined back to where it was in the early 1980s, when a considerably smaller proportion of women worked full-time.
2 Please see Fighting Solvency Time Bombs with Liquidity Bazookas, Amphora Report Vol. 2 (October 2011). Link here.
3 That new money entering the economy benefits primarily those who first receive it is hardly a novel idea but it is one that neo-Keynesian economics conveniently glosses over. Economist Richard Cantillon recognised the ‘non-neutrality’ of money way back in the 18th century and the way in which new money distorts relative prices is called the ‘Cantillon Effect’. For more on this important concept, please see the Wikipedia article linked here.

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