By John Richardson
BUILDING UP lots of debt isn’t a problem if it leads to inflation that then inflates-away the value of some of that lending.
And debt-induced healthy increases in inflation also show that all of that lending has worked, as these levels of inflation point to snug employment markets and strong wage growth.
Ample availability of jobs that pay good money also guarantee strong demand growth as a.) Consumers have more money in their pockets, and b.) They are anxious to buy goods and services now, rather than tomorrow, in order to hedge against future price rises.
In such circumstances, the above chart – from a June 2017 Bank for International Settlements (BIS) study – would not be a cause for alarm as it would indicate the success of the ultra-loose monetary policy since 2009.
The only challenge central banks would then face would be raising interest rates at the right pace, and by the right amounts, that avoid choking-off inflation to the point where the economic recovery comes to an end.
But we are in a vastly different world to what the Fed, and all the other western central banks, imagined when they began their ultra-loose monetary policies back in 2009. This second chart, from a 2016 McKinsey study, helps explain this vastly different world.
It is all about demographics
The rise of the “gig economy” and zero-hours contracts means nothing has changed since 2014 – the end of the McKinsey survey period. In fact, conditions for squeezed middle-income earners in Western economies have got worse.
This explains why inflation, despite eight years of record-high levels of monetary stimulus, remains either close to the bottom of or below the target ranges set by central banks.
This is therefore why we should be very worried by the chart at the beginning of this post – and by the same BIS study which finds that global aggregate debt ratios are almost 40 percentage points of GDP higher than a decade ago.
The anomaly of tight labour markets but poor or even negative wages growth has been explained away by automation reducing the bargaining power of workers. As robots and artificial intelligence get smarter and smarter, better-paid jobs are increasingly being done by machines. This has concentrated employment growth in lower-value occupations, such as fast food restaurants.
And, of course, globalisation is also blamed for the collapse of the bargaining power of workers with the backlash against jobs drifting overseas helps explain Donald in the White and the Brexit vote.
I won’t get into the arguments of the rights and wrongs of these two theories behind stagnant wages and thus disappointing inflation rates in the West.
All I will say is that both of these arguments miss the main point. The main point is demographics. The retirement of the Babyboomers means that no matter how much longer interest rates remain low, and how much more debt is built-up in developed economies, inflation is still likely to fail to consistently return to the levels we saw in the 1970s and 1980s.
The reason is the absence of enough young people joining the workforce to replace all the retiring Babyboomers. Too much supply is, as a result, chasing too much demand, leading to deflation rather than inflation.
Meanwhile, China, which is responsible for much of the global debt build-up since 2009, is a different story but no less alarming.
Wages growth isn’t a problem in China – in fact it is instead a challenge as its population also ages. It is, as a result, losing competitiveness in lower-value manufacturing industries.
China’s problem is instead centred on the huge misallocation of lending since 2009.
Manufacturing industries have been pushed into major oversupply, with increased steel and chemicals production exacerbating an already existential environmental crisis.
Highly opaque and complex lending practices have helped inflate a socially, politically and economically unsustainable real-estate bubble, whilst the opacity and complexity of those practices means that nobody has a clear idea about the true extent of China’s debts.
The “unprecedented challenges” of policy normalisation
The “stop go” nature of the lending bubble in China has driven global economic growth levels – and the strength of oil, chemicals and other commodities prices – since 2009. Up until the end of last year, this had been in three phases:
- China increased lending by $10 trillion in 2009 when its nominal GDP was only $5 trillion. This contributed to a surge in oil prices and supported the global economy.
- Growth in lending slowed in 2014, which was one of the factors behind the decline in global oil prices from around September of that year. Commodities prices in general slid on a slowdown in the Chinese economy. Lending was down by $4 trillion by 2015.
- Last year, China once again took the controls off its financial system, resulting in a renewed surge in credit growth. This once again boosted commodities prices and the global economy.
We are now in the midst of phase four as China again sharply reduces growth in lending. This is occurring at the same time as the Fed tightens monetary policy and as other western central banks look to pull-back on monetary stimulus.
“Policy normalisation presents unprecedented challenges. [It could] trigger or amplify a financial bust in the more vulnerable countries, wrote the BIS in its June 2017 report.
Sure, China could back down – although I believe this unlikely because of Xi Jinping and his fellow reformers’ commitment to reform and their stronger political position.
The Fed, too, could reverse course. There are no guarantees that the Fed will further raise interest rates in September, and if global economic condition worsen, perhaps interest might even lowered again.
But if China and/or the Fed reverse course it wouldn’t do any good. The only result would instead be more bad debts that would eventually have to be paid back.
Chemicals and other companies must therefore build scenarios around global credit tightening versus even more air been pumped into the world’s debt bubbles.
Assuming that China and the Fed to maintain their current policies, the BIS in the same June 2017 report warns: “Policy normalisation presents unprecedented challenges. [It could] trigger or amplify a financial bust in the more vulnerable countries”.
The study adds that the banking system is as under as much strain in some parts as Asia as it was in Europe and the US in 2008. For example, off-shore dollar debt outside US jurisdiction – with no direct lender-of-last-resort behind it – has risen by 50% to $10.5 trillion since 2008.
”They definitely checked your pulse”
Fed chair Janet Yellen doubts whether she will see another financial crisis. I hope she is right, but ominously.
But as this MoneyWeek article points out:
There are plenty of other signs of froth. Global government bonds, underpinned by trillions of central banks’ printed money, are absurdly overpriced. Lending standards have slipped, too, notes the Buttonwood columnist in The Economist.
In the EMEA region (Europe, the Middle East and Africa), the proportion of the loan market that is covenant-lite (accompanied by few safeguards against a deterioration in the debtor’s business) has reached 66%. That’s up from 27% in 2015.
US stocks have only been pricier on two occasions: before the collapses of 2000 and 1929.
All this debt means the world economy is more sensitive than ever before to dearer money. And monetary policy cannot stay loose forever.
Other signs of excessive risk include the US auto loans market. As the FT wrote back in May:
Just as with mortgages, the car loan business has grown rapidly. Total auto loans outstanding came to $1.17tn at the end of the first quarter of this year, according to the New York Federal Reserve, up almost 70% since a post-crisis trough in 2010. That has helped push total household debt to $12.7tn, surpassing the 2008 peak.
Is this another sub-prime mortgages disaster? Probably not. Steve Eisman, the fund manager who helped inspire The Big Short, the best of all the books about the US mortgage crisis, told the FT: “At the height of subprime mortgages, the standard was, ‘can you breathe?’ It never got that bad in subprime auto. They definitely checked your pulse.”
But still, levels of US consumer auto debt suggest a sharp fall in new vehicle sales – especially as the Fed appears to be in tightening mode. Rising interest rates will make new auto loans less affordable.
Further, the Fed’s giant monetary stimulus programme has created false demand. US consumers were lured into buy vehicles that they didn’t ’really need because financing terms seemed too good to turn down.
Professor Frank Partnoy, also in an FT article, warns that collateralised loan obligations represent a threat similar to the collateralised debt obligations that were behind the 2008 Global Financial Crisis.
And assuming about the extreme risks for monetary tightening, what happens if the White House is successful in repealing the Dodd-Frank legislation?
“Expect a financial crisis in about five minutes,” says a former Reuters financial journalist.
You may disagree, but you still need to plan for being wrong and thus add this to your list of risk factors.