Our economy – dealing with debt in the post Global Financial Crisis/QE era
14 November 2017
Are we on the brink of a recession, have boom bust cycles been eliminated and how volatile might markets be going forward? David Jane, manager of Miton’s multi-asset fund range, takes a view.
‘This time is different’ are the most dangerous words in investment and also the name of a book on financial crises and debt deflations by Reinhart and Rogoff.
While the book was criticised in some quarters for data inaccuracies, its basic thesis that when countries become over indebted they must in some way deal with that – either through default or inflation – remains valid. At the same time, they predicted that unwinding of a debt bubble would take approximately six to eight years, before growth would then reaccelerate.
This bull market has been characterised by a significant number of commentators expecting a reversion to the past era and/or concerned that the debt hasn’t been properly dealt with – therefore expecting the market to crash at any point. However, a few have been pragmatically looking for the opportunities created by the cheap money era, whether in business models that can support high amounts of cheap debt, or in bond markets where yields have stubbornly refused to rise.
To understand what the future may hold, we first need to understand how the post-Global Financial Crisis (GFC)/QE era is different from the previous era. In the previous era, economies were to some degree driven by the credit cycle. Banks would lend, driving up their profitability and increasing their ability to lend to a point where the economy became ‘overleveraged’. Banks would then reduce their lending, leading to a contraction in economic activity and companies to fail. This era arguably came to an end with the GFC where the excess debt was moved from the financial sector to the government sector, rather than dealt with through default, saving jobs and homes in the process. Some argue that the debt hasn’t been dealt with and as a consequence, the proper amount of pain hasn’t been taken.
Alternatively, you could suggest that there isn’t a correct amount of pain (except no pain) and therefore, dealing with the excess credit through nationalising is a better process. Why bankrupt a viable business simply because it has the wrong capital structure at the cost of jobs and productive output, when through the mechanism of ultra-low rates, the business can continue a slow decline?
The process of creative destruction, and the volatility that goes with it, was presumed, in the previous era, to be a necessary part of the system, but in the current era isn’t occurring. Is it a bad thing that a so called ‘zombie company’ that only just covers its interest bill and has no prospect of repaying its debt, is allowed to continue, rather than seeing the capital that supports it and the jobs it creates destroyed? Some argue that it is this destruction that frees resources for more productive businesses, although it’s difficult to see how destroying wealth creates more investment.
Has the past debt been dealt with? There is an argument that the huge amount of debt assumed by governments to deal with the crisis and bought by the central banks should be ignored. The fact that one arm of the state owes money to another is largely irrelevant, so long as you don’t assume that the central bank must inevitably sell that debt on to the market. So, rather than deal with the debt through default or inflation, it has been dealt with by monetisation, giving central banks a new stabilisation tool in the process.
It looks much more likely that central banks’ holdings of securities will be used as an ongoing policy tool in order to smooth the economy and reduce volatility. We have argued many times since the GFC that the central banks, having been given the power of direct intervention, are unlikely to voluntarily give it up. So, while central bank holdings are being reduced at present to dampen potential excesses, at the first hint of risk to economic instability they will surely be back using the tools they now have to avoid a crisis.
What are the potential problems of this new era and what are the implications? Firstly, the existence and creation of ever more ‘zombie companies’, perhaps better termed highly leveraged mature businesses, could crowd out opportunities to use those assets (people and fixed assets) more productively. I’m not sure that is a very strong argument in an economy when workers will happily move to better paid jobs and most new businesses use proportionately less tangible assets than mature ones.
More realistically, are the new tools sufficient to reduce the boom bust cycle or even eliminate it. The jury may still be out on that one, but there’s some evidence of the current system being successful at stopping problems feeding through to a more widespread economic contraction – whether the Greek financial crisis, the Shale bust or the Chinese equity and property bubbles.
We are always pragmatic and as a consequence will not sit firmly in either camp. However, we don’t see evidence that we are on the brink of a recession or that cycles have been eliminated. What we can see is that the current system leads to protracted periods of low volatility combined with asset bubbles in various asset classes that appear to inflate and then deflate, without huge implications more widely. While this may change, investors should remain vigilant but pragmatic, avoiding the greatest downside risks while participating in potential returns.
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