Size Does Matter

So I found myself listening to the smartest economists in the world on CNBC today because I was starting to feel less than euphoric when I woke up this morning.  There is no drug like the soothing chant of the collective talking heads on CNBC.  Just as I was falling back into my trance like state of euphoric BTFATH daily ritual (which of course is the ‘new normal’) my dogs barked at some ducks inconsiderately taking refuge out on the lake shattering my zen.  So there I was back to reality which made me think….. I know we’re not supposed to do that these days and likely I was put on some NSA database for doing so.  But to the point I started thinking about the 3% GDP growth that we were supposed to get for this year that then morphed into the second quarter will be 3% and now today the Fed’s Plosser changed it again saying “We should get to a 3% annual growth rate later this year” (yeah that was a sneaking way of pushing expectations back using equivocation – it sounds like he’s saying 3% GDP growth for the year).  His actual meaning is that he doesn’t expect 3% to happen now in Q2 or perhaps even Q3 but maybe by Q4 we’ll see a quarterly annualized print of 3%.  This is very different from the chanting heads looking for a 4%-5% annualized print in Q2.

But so let’s say we do get to a 3% annualized GDP print sometime this year.  Is that really a good thing?  I mean when we look at historical GDP that’s been sustainable growth.  But is it still a sustainable growth rate?  What I mean by that is has everything else remained the same?  For instance if my household income growth has always been 3% and that has just sustained the growth of my expenditures, debt and savings then growing 3% going forward is only sufficient growth if I haven’t increased my expenditures, debt and savings.  So is that the case for the overall economy?  Have we kept everything else proportional?  If we have not then it is not correct to assume our historical sustainable growth rate is our forward sustainable growth rate.  Have a look at the following charts.  Both charts depict (for different periods) total debt/GDP and quarterly net change in GDP – Debt (simply indicating if we added more GDP or more debt in a given quarter).

The charts clearly show us that we are adding more debt than GDP on a quarterly basis, in fact 79% of the last 192 quarters have added more debt than GDP.  Moreover, since 2008 the net change has been hugely skewed toward greater debt (as depicted in the second chart).  So back to my household analogy.  This means that we are not holding everything else equal.  Remember the historical sustainable growth rate of GDP is 3% and so the Fed and most other economists are touting that as the number we will certainly get back to maybe anyway sometime later this year perhaps.  But again, is 3% a sustainable growth rate given the amount of debt we have been adding to achieve that hopeful forward looking not yet achieved 3% growth rate??  No!!! Of course not!  If you were increasing your debt levels by 25% each year would the old annual 3% raise be sufficient?  Of course not.  So the notion that once we hit 3% annualized GDP growth means everything is again honkey dory for you and me is one of those poor assumptions our mothers warned us about.  Meaning it simply is not factual and to base the hopes of an entire nation on that poor assumption is deceptively irresponsible and somewhat cruel.  I mean if you’re going to kick me in the nuts please just do it, don’t taunt me.

The sad reality is that size does matter, of debt that is (cheeky).  We have been trained to believe that debt simply does not matter because we have the ability to monetize debt, which means even when no one else wants to lend us money we can just print it out of thin air (we are monetizing between 70% and 90% of debt auctions now).  The ability to monetize debt means that we do not have to worry about what our balance sheet looks like because we are the only ones looking at it and we don’t care because we have a golden goose in the Fed.  That concept may be be true if, and this is becoming a very big if, there will always be strong demand for the US dollar versus the supply of dollars available globally.  The problem with the printing money out of thin air to cover endless spending is that it creates a huge supply of dollars.  If demand for dollars had a downward shift due to say no longer being accepted as the world currency the purchasing power of the dollar would see a significant decline.  So that $100 to fill up your truck now could cost you $400.  A loaf of bread costing you $2.50 now would cost you $10.00.  Just as a reminder Russia is actively signing large commodity deals to be non USD transactions.  In the past six weeks Putin has signed approximately $500 billion worth of non USD deals that would have previously been done in USD.  The result is reduced demand for USD and it also opens the flood gates for other nations to do the same.

But the charts depict a two sided problem, debt as we’ve covered and GDP growth.  One very large problem, which is apparent to anyone able to step back from the trees of talking heads and see the forest of reality is that 3% growth has been stubbornly difficult to get back to let alone a new higher equilibrium growth rate of GDP.  The following chart helps explain the faltering mechanism preventing growth.

You can see from the chart that there was a positive correlation between the trendlines of debt and money velocity from the mid 1960’s through the 1990’s.  However, an inverse correlation took effect around 1999 and the inversion has been steepening ever since.  The message here is that we are utilizing debt less and less efficiently.  Money velocity is a measure of how much national income is being generated per dollar of M2 money supply.  M2 money supply since 1999 has been going directly to increases in debt.  The next step is to then understand why the inversion took place in 1999.  The fact is that financial engineering really kicked into high gear during the tech bubble.  That is, companies began looking to financial markets as legitimate alternatives to capex investments en masse.  This, initially slowly, lead to a decline in fixed reinvestment which was substituting toward non expansionary projects such as dividends, treasury stock and acquisitions.  This became ever more pronounced subsequent to the credit bubble bursting.  Refer to the grey bars on the chart above which indicate periods of recessions.  Notice that money velocity declines for a period after a recession but then at some point reverses.  This is a natural part of the bust boom cycle of monetary policy.  Recessionary periods bring with them low borrowing rates to stimulate the economy.  This has worked in all other periods of post recession recovery until the credit bubble.  Note the decline in money velocity post 2008.  There is a short period where money velocity reverses and begins to increase at the end of 2009.  This would have normally been the natural recovery period.  However, because U6 unemployment was still north of 15% corporations recognized that consumer demand remained far too low to risk fixed reinvestment even with essentially zero borrowing costs.  The void of fixed reinvestment only furthered the problem of narrowing income distribution by not creating jobs that lead to consumer demand.  Rather, corporations also recognized the Fed was targeting an upward moving financial market, essentially backstopping the market.  This created an almost risk free investment into the financial markets and so corporations who must allocate money to the optimal asset (meaning highest return given risk) did what they are trained to do which is optimally allocate its resources, which was the financial market, not fixed investment projects.  The problem is that financial market allocations do not create jobs.  And so after a short period in late 2009 of recovery in money velocity it quickly reversed and has been collapsing ever since.  This is the mechanism that will make it extremely difficult for the broad economy to get back to 3% GDP growth let alone, the new real equilibrium growth rate.

To wrap this up as I know it is getting a bit wordy the 3% GDP print that we have been hearing is just around the corner since about 12 corners ago is a red herring in that it is being touted as a meaningful figure when in fact it will now take a much higher growth rate to sustain our new fiscal position.  The huge amount of debt we have amassed has changed where we need to be in terms of GDP growth and structural changes in risk allocation will make it very difficult to get GDP growth where it needs to be.  If we cannot get to a new sustainable level of GDP growth we will, in the best case, drudge along in an era of ever increasing prices but declining disposable income or, in the worst case, we will discover the woes of a collapsing economy.  The latter although sounds worse perhaps than the former at least allows for a new beginning.  Other nations have gone down this difficult path and managed to come out the other side, while some empires have disappeared as a result.  Here’s hoping for the other side.