August 2010 Economic Update: Too Much Leverage and Too Little Demand

Our view is that the world faces four critical and interrelated challenges today, whose potential effects are non-linear. This makes them both hard to understand, and raises the likelihood that we will underestimate their potential impact and will be surprised by the rapid changes they may cause. The first challenge is the fragile nature of the global financial system, in which a very large amount of debt of highly uncertain quality rests on a very thin capital base. On the other side of this equation is the precarious position of many parties that are struggling to repay and/or rollover that debt, including households, some corporations (e.g., commercial property developers), and various levels of government, up to and including some sovereign nations.

The second challenge is the weakened and imbalanced state of global aggregate demand. In many countries, private sector balances (i.e., the difference between savings and investment) have swung from strongly negative to strongly positive since the global financial crisis exploded in 2008, as investment has been cut back and strenuous efforts have been made to save more in order to reduce outstanding debt. The resulting reduction in private sector demand has usually been balanced by a sharp expansion of government deficits and attempted expansion of the money supply, in order to avoid an even deeper economic contraction and more severe rise in unemployment. However, in a world that has become globally interconnected to a degree not seen since the early 1900s, the benefits of these government stimulus programs have spread beyond domestic borders. This has slowed the reduction in aggregate demand in nations that have been most reliant on exports for economic and employment growth, such as China, Germany, and Japan. In theory this has bought time for these nations to take steps to expand domestic demand (which in turn would allow nations running substantial current account deficits, such as the U.S. and U.K., to reduce them, and replace government deficits with rising exports as a source of GDP growth). Indeed, this is the fundamental assumption that underlies the "muddling through" scenario, which describes a slow, but steady recovery from the Great Recession. In practice, however, we are seeing once again the truth of the old adage that "no plan survives its first contact with reality."

The third challenge facing the world economy is the risk that developed economies will slip into an extended period of deflation, similar to Japan’s experience since the bursting of its property and equity bubble in 1989. This challenge is the subject of this month's feature article.

The final challenge we face is maintaining the legitimacy of various political institutions, both international (e.g. rules governing multilateral trade and capital flows) and domestic, in the face of economic and social stresses not seen since in most countries since the 1930s.

In essence, the "muddling through" scenario assumes that all these challenges will be met, and that the main price we will pay is a prolonged period of slower economic growth (the truly rosy scenario assumes that rising domestic demand in emerging markets will cause them to become the new motor of the world economy, which in turn will return global growth to its previously high levels). The downside scenario assumes that we will fail to meet one or more of these challenges, and, given their complex interrelationships and non-linear effects, the result will be an extended period of stagnation whose severity will take many people by surprise.

In our assessment of the new evidence that each month presents, we continue to use the "Analysis of Competing Hypotheses" (ACH) methodology, whose essence is the conscious search for information that is credible and has a high diagnostic value (i.e., it has a low probability of occurrence under more than one scenario). In this way, ACH helps to protect us from the confirmation bias -- the tendency to attend to, and give greater weight to information that confirms your preferred view, rather than information that contradicts it (see "Forecasting Accuracy and Cognitive Bias in the Analysis of Competing Hypotheses" by Andrew Brasfield).

Let us now turn to a review of recent evidence about the outcome of the first two of the four key challenges facing the world economy. The third, deflation, is the subject of this month's feature article. The fourth, maintenance of political legitimacy, will be the subject of next month's economic update.

Reducing High Leverage

In the U.S., recent news items continue to paint a grim picture on the state of the leverage challenge in the household sector. For example, in the Federal Reserve Bank of New York's most recent Quarterly Report on Household Debt and Credit, they report that at 30 June 2010, "11.4% of outstanding debt was in some stage of delinquency, compared to 11.2% a year ago. Currently about $1.3 trillion of consumer debt (of which about 80% is mortgages and home equity lines of credit) is delinquent, and $986 billion is seriously delinquent (at least 90 days late)."

Data from the housing markets continue to be strongly negative. A new report from Experian and Oliver Wyman found that "nearly one in five mortgage defaults through the first half of 2009 [note the lag in this data] were strategic, where borrowers who appeared to have the capacity to repay their mortgages stopped doing so...The absolute number of strategic defaults increased 53% over the same period in 2008." ("Wall Street Journal, 28Jun10, "Study: Nearly One in Five Mortgage Defaults Are Strategic"). Another article in the New York Times concluded that "the housing bust that began among the working class in remote subdivisions and quickly progressed to the suburban middle class is striking the upper class in privileged enclaves...Whether it is their residence, their second home, or a house bought as an investment, the rich have stopped paying the mortgage at a rate that greatly exceeds the rest of the population. More than one in seven homeowners with loans in excess of a million dollars are seriously delinquent...' The rich are different: they are more ruthless' said CoreLogic's senior economist." (New York Times, 8Jul10, "Biggest Defaulters on Mortgages are the Rich", by David Streitfeld).

Uncertainty about the extent of bad loans and loan guarantees on the books of Fannie Mae and Freddie Mac in the U.S. continues to rise. This is a critical issue, for, as Gillian Tett noted in the 22Jul10 Financial Times, "the volume of outstanding mortgages backed by these two institutions now stands at $5,500 billion, or about half the U.S. mortgage market." She notes that "guesstimates about the size of the future taxpayer liability [for bad mortgage debt held or guaranteed by the two organizations] now range from $390 billion to almost a trillion dollars." She goes on observe that, "so is there any chance of seeing a proper stress test of this exposure? Or exit strategy? Don't bet on that soon. These days, [Fannie and Freddie] are the only thing keeping the U.S. mortgage and housing sector afloat, because private securitization has effectively collapsed: last year, for example, nine our of ten mortgages were underwritten by Fannie and Freddie."

Elsewhere in the financial system, there is a great deal of cynicism about European bank stress tests that did not include a scenario with sovereign defaults (e.g., by Greece). As European banks have a substantial amount of sovereign debt on their balance sheets, this omission has resulted in far less of an improvement in investor confidence that regulators had probably hoped for (see, "A Test Cynically Calibrated to Fix the Result" by Wolgang Munchau, Financial Times, 25Jul10).

There has also been an upsurge in papers and articles on the subject of sovereign default. In "From Financial Crash to Debt Crisis", Rienhart and Rogoff, examine a long historical time series and conclude that "the evidence confirms a strong link between banking crises and sovereign default across the economic history of a great many countries, advanced and emerging alike...Private debt surges are a recurring antecedent to banking crises...Banking crises often precede or accompany sovereign debt crises...Public borrowing accelerates markedly ahead of a sovereign debt crisis; governments often have 'hidden debts' that far exceed the better documented levels of external debt...During the final stages of the private and public borrowing frenzy on the even of banking and debt crises and (most notoriously) bursts of hyperinflation, the composition of debt shifts distinctly toward short-term maturities." Elsewhere, in the 26May10 New York Times, the hedge fund manager David Einhorn writes (in "Easy  Money, Hard Truths"), "The question is this: If we don't change direction, how long can we travel down this path without having a crisis? The answer lies in two critical issues. First, how long will the capital markets continue to finance government borrowing that may be refinanced but never repaid on reasonable terms? And second, to what extent can obligations that are not financed through traditional fiscal means be satisfied through central bank monetization of the debts -- that is, by printing money?" Einhorn cautions that, "at what level of government debt and future commitments does government default go from being unthinkable to inevitable, and how does our government think about that? ... Modern Keynesianism works great until it doesn't. No one really knows where the line is... I don't believe a United States debt default is inevitable. On the other hand, I don't see the political will to steer the country away from crisis...[Moreover], allowing borrowers, including the government, to get addicted to unsustainably low rates creates enormous solvency risks when rates eventually rise."

On the other side of the pond, in their Global Economics Note on 18Jun2010, Morgan Stanley noted that "For some time now, the Euro has been caught in a vicious circle where the sovereign debt crisis and the bank funding crisis are mutually reinforcing each other. Sovereign rating downgrades have eroded confidence in the balance sheets of the banks, most of which own government bonds and are guaranteed, directly or indirectly by governments. This, together with higher borrowing costs for fiscally challenged countries, has raised funding costs for banks in the interbank market and in the capital markets. In turn, the banking sector woes raise additional question marks in the markets about sovereign creditworthiness, as more banks may have to be bailed out by governments that already run large fiscal deficits and struggle to limit the rise in public debt."

On 20Jul2010, Michal Pettis posted (on China Financial Markets, www.mpettis.com) an excellent article on "Do Sovereign Debt Ratios Matter?" I was struck by how much it resonated with my own experience many years ago in Latin America (experience which, in truth, I never imagined would one day be relevant in the developed world). Pettis argues that "there are at least five important factors in determining the likelihood that a country will suspect or renegotiate certain types of debt. First, of course debt levels, perhaps measured as total debt to GDP, or external debt to exports, matter...Second, the structure of the balance sheet may be much more important than the actual level of debt...Foreign currency and short term borrowings servicing cost declines when confidence and asset prices rise, and rise when confidence and asset prices decline...making the good times better and the bad times worse...Third, the economy's underlying volatility matters...less volatile economies can safely bear more debt...Fourth, the structure of the investor base matters...Contagion is caused not so much by fear, as most people assume, but by large amounts of highly leveraged positions, which force investors into delta hedging...buying when asset prices rise, and selling when they drop...Fifth, the composition of the investor base is also important...A sovereign default is always a political decision, and it is easier to default if the creditors have little domestic political power or influence."

In "Unpleasant Surprises", Bandiera, Cuaresma, and Vincelette of the World Bank uses a model averaging technique to examine sovereign defaults in 46 emerging market countries between 1980 and 2004. They find that, "in addition to the level of indebtedness, the quality of policies and institutions is the best predictor of default episodes that occurred in countries with relatively low levels of debt. For countries with higher levels of debt (defined as external debt above 50% of GDP), macroeconomic stability, as measured by the rate of inflation, plays a robust role in explaining differences in default probabilities." As we have repeatedly noted in our writing, the authors of this paper also find that combining the results of models that use different methodologies produces the most accurate forecasts.

Elsewhere, Calculated Risk (www.calculatedriskblog.com), has been running an outstanding series on sovereign default. We highly recommend the 18July10 posting on "What Happens if Things Go Really Badly? $15 Trillion of Sovereign Debt in Default."

At the sub-sovereign level, coverage of the municipal financial crisis in the United States is growing more intense and insightful. As our readers know, this crisis has multiple roots, including very large unfunded pension and post-retirement health care obligations to public sector employees, growing social program costs, rising debt costs, and political resistance to higher taxes. Something has to give -- the only question in our mind is when it does, and how ugly it will be. City Journal’s Steve Malanga has been writing about this issue for years, and his latest article ("The Muni Debt Time Bomb" in the Summer 2010 issue) is characteristically insightful, as is Joel Kotkin's  examination of the political roots of the crisis in California, in the same issue ("The Golden State's War on Itself: How politicians turned the California Dream Into a Nightmare"). We strongly recommend it.  Elsewhere, in the New York Times, Roger Lowenstein writes about "The Next Crisis: Public Pension Funds" and highlights their extreme underfunding. Perhaps the biggest bombshell in the unfolding muni crisis landed rather quietly recently (perhaps this is just the calm before the storm) when Professors Robert Novy-Marx and Jonathan Rauh published their latest analysis of public pension fund deficits. In "Policy Options for State Pension Systems and Their Impact on Plan Liabilities", the authors paint a very grim picture of what lies ahead. After evaluating the impact of the "public pension reform" measures undertaken thus far in different municipalities, and assuming they were adopted everywhere else, the authors conclude that taxpayers likely will be asked to bear the cost of the approximately $1 trillion in unfunded liabilities that remain after the proposed "reforms." To put it bluntly, this is further confirmation that problems in the municipal debt market are sure to get ugly, and will eventually pit taxpayers, public sector unions, social program supporters and bondholders against each other. Finally, just as the fight is about to heat up, the SEC appears to be taking long-overdue notice of the problems in the U.S. municipal debt market, and has recently launched an enforcement action against the state of New Jersey, alleging fraud in its bond disclosure documents (see "Pension Fraud in New Jersey Puts Focus on Illinois", by Mary Williams Walsh, New York Times, 20Aug10). We have no doubt that the SEC's efforts will soon spread to other states, adding further fuel to the fire that is building in this sector of the global fixed income market.

The final work on the growing sovereign debt crisis, and the paper vying for the title of "biggest bombshell" this month, is a recent research report by Arnaud Mares of Morgan Stanley. In "Ask Not Whether Governments Will Default, But How", he points out that, fiscally, the emperor has no clothes. His argument starts with the familiar point that debt/GDP ratios are misleading, because they omit liabilities for future social security and retiree health care benefits. To this he adds the equally important point that debt/GDP ratios are also deceiving because "whatever the size of a government's liabilities, what matters ultimately is how they compare to the resources available to service them. One benefit of sovereignty is that governments can unilaterally increase their income by raising taxes, but they will only ever be able to acquire in this way a fraction of GDP. Therefore, debt/GDP provides a flattering image of government finances. A better approach is to scale debt against actual government revenues. An even better approach would be to scale debt against the maximum level of revenues that governments can realistically obtain using their tax raising power to the full. This is a function of the people's tolerance for taxation and government interference." Mares then uses this framework to make his emperor has no clothes point: If the present value of maximum future tax revenues is less than the present value of future government liabilities, the government is insolvent, and "some or all of its stakeholders must suffer a loss: either taxpayers (through a higher tax burden), or beneficiaries of public services (through lower government expenditures) or bondholders (through some form of default)." Observing that today it appears that many governments are, using this framework, insolvent, Mares concludes that "it is not whether to default, but how and vis-à-vis whom. What this means is that governments will impose a loss on some of their stakeholders. The question is not whether they will renege on their promises, but rather upon which of their promises they will renege and what form this default will take. From the perspective of sovereign debt holders, this translates into two questions: (1) Does their claim on governments rank senior enough on other claims to fully shelter them from losses? And (2), If it does not, what form will their loss take?" Noting that bondholders have thus far avoided losses, Mares asks "can this realistically continue forever?" He concludes that "whether bondholders will be asked to share the pain depends on (1) the intensity of the conflict that opposed them to other stakeholders, which today is likely stronger than it has ever been; and (2) the extent to which the interest of bondholders are aligned with those of the most political influential constituencies." Regarding the latter, Mares concludes that the interests of bondholders are not well aligned with the interests of the most politically powerful consitutency. "The constituency of the elderly is the biggest competitor to bondholders because of the considerable size of its direct claims on future government revenues, their reluctance to relinquish these claims, and the reduced share of outstanding government bonds that they hold today, particularly relative to foreign investors."

The ongoing problems in some segments of the corporate debt market are also drawing more coverage. For example, PIMCO recently published a research note titled "Distressed Debt: The End is NOT Near." They note that "even if a company is successful in accessing the high yield market, they are generally refinancing low-cost bank loans with rates of less than 4% with new bonds costing 10% or more." Judging from very high new issue volume, particularly in the high yield market, in recent weeks, there is clearly a market for this debt, among, we would guess, fixed income investors who are "stretching for yield", and probably not adequately pricing the additional default risk they are taking on. As PIMCO concludes, "we view the unprecedentedly quick recovery of corporate credit spreads from historic highs to long-run averages as unsupported by fundamental economic improvements."

As we have noted in previous issues, leverage problems are not confined to the developing world. As many writers have noted, there is increasing evidence that a very substantial property bubble has been building in China, fed by that country's aggressive credit growth after the 2008 crisis. A new research paper provides further evidence against the "strong growth in China" story that underlies the muddling through scenario. In "Evaluating Conditions in Major Chinese Housing Markets", Wu, Gyourko and Deng conclude that "housing markets look very risky based on the stylized facts we document. Price-to-rent ratios in Beijing and seven other large markets across the country have increased from 30% to 70% since the beginning of 2007. Current price-to-rent ratios imply very low user costs of no more than 2% to 3% of house value. Very high expected capital gains appear necessary to justify such low user cost of owning...That people might believe in such high appreciation is not incredible given the recent history of Chinese house prices. However, this sort of backward looking expectation formation is a classic element of bubble psychology.... Our calculations suggest that even modest declines in expected appreciation would lead to large price declines of over 40% in markets such as Beijing, absent offsetting rent increases or other countervailing factors. Price-to-income ratios also are at their highest levels ever in Beijing and select other markets...Real constant quality land values have increased by nearly 800% since the first quarter of 2003, with half that rise occurring over the past two years...The magnitude of the increase in land values over the past 2-3 years in particular in Beijing is unprecedented to our knowledge. Not only do these increases post-date the Summer Olympics, but the recent price surges in early 2010 suggest a relationship to the Chinese stimulus package which itself is temporary...[Moreover], state-owned enterprises controlled by the central government have played an important role in this increase, as our analysis shows they paid 27% more than other bidders for an otherwise equivalent land parcel...The role of state-owned enterprises is potentially worrisome. It could be that these entities are superior investors and are purchasing sites that are of especially high quality in ways that we cannot control for in our empirical analysis. However, it also could be that moral hazard is at work here, as these entities are thought to have access to low cost capital from state-owned banks and may believe that they are 'too big to fail.' If this is the driving force, then prices are being bid up as one arm of the government buys from another." In our experience, academic research doesn't get more damning than this report.

Growing and Rebalancing Global Demand

Following on our review of recent developments on the leverage front, we'll begin our discussion of global demand with a new paper from the IMF. In "Public Debt and Growth", Kumar and Woo explore the impact of high public debt on economic growth. They find that "the empirical results suggest an inverse relationship between initial debt and subsequent growth, controlling for other determinants of growth. On average, a 10 percentage point increase in the initial debt/GDP ratio is associated with a decrease in real per capita GDP growth of around 0.2% per year, with the impact being somewhat smaller in the more advanced countries. There is also some evidence of non-linearity, with higher levels of initial debt having a proportionately larger negative effect on subsequent growth. Analysis of the components of growth suggests that the adverse effect largely reflects a slowdown in labor productivity growth, mainly due to reduced investment and slower growth of the capital stock."

Another recent look at economic history also finds that the historical precedents are not encouraging when it comes to a quick return to health rates of aggregate demand growth. In "After the Fall" Carmen and Vincent Reinhart examine "the behavior of real GDP, unemployment, inflation, bank credit, and real estate prices in a twenty one year window surrounding selected adverse global and country specific shocks and events." They find that "real per capita GDP growth rates are significantly lower during the decade following severe financial crises...The median post-financial crisis GDP growth decline in advanced economies is about one percent...In the ten year window following severe financial crises, unemployment rates are significantly higher than in the decade that preceded the crisis...Over an eleven year period (encompassing the crisis year and the decade that followed), about 90 percent of the observations show real house prices below their level the year before the crisis...In the decade prior to a crisis, domestic credit/GDP climbs about 38 percent, and external indebtedness soars.  Credit/GDP declines by an amount comparable to the surge after the crisis. However, deleveraging is often delayed and is a lengthy process lasting about seven years."

Now let's move on to the most recent OECD Economic Outlook, which was released late in June. It provides a succinct summary of the baseline or "muddling through" scenario, and highlights the optimistic assumptions that underlie it. "For OECD countries, the starting position (in 2011) is far from macroeconomic equilibrium, with large output gaps and fiscal balances which in many countries are far away from levels that would be consistent with stable government debt. Given the size and combination of these two imbalances, and the wish to consider scenarios in which debt levels are brought back to pre-crisis levels the time horizon of the baseline scenario has been extended (to 2025) compared with previous OECD baseline exercises. Most of the assumptions underlying the scenario tend to err on the optimistic side, including that: the crisis itself has no permanent adverse effect on the rate of growth of total factor productivity or potential output; output gaps are closed by 2015 as a result of sustained above-trend growth with output growing in line with potential thereafter; most countries do not experience deflation despite continued negative output gaps over this period, and eventually experience a smooth return to targeted inflation by 2015; and countries are assumed to address the budget implications of ageing and trend health cost increases through compensatory or offsetting budget saving...The scenario builds in a reduction in the level of potential output due to the crisis so that compared to OECD medium-term projections made prior to the crisis (e.g. OECD, 2008), the level of area-wide potential output is lowered by about 3%, with most of this reduction already having taken place by 2011. From 2012 onwards, the growth rate of OECD-wide potential output recovers to average about 1.9 per cent per annum, but this is still below the average growth rate of 2.3 per cent per annum achieved over the seven years preceding the crisis...Unemployment is falling in all countries, with the area-wide unemployment rate down from 8.50 per cent in 2010 to a rate of 6.25 per cent by 2015 and 53/4 per cent in 2025..."

"As a stylised assumption, a degree of future fiscal consolidation has been incorporated in the baseline scenario which is sufficient to stabilise the ratio of government debt to GDP over the medium term. However, the relatively modest pace of this consolidation (1/2 per cent of GDP per annum reduction in the underlying primary balance for as long as it takes to stabilise debt) is such that in most cases there is a further build-up in the government debt to GDP ratio before it does stabilize. The slow pace of consolidation and the high levels of debt reached may in practice not be sustainable but these assumptions are chosen to have a basis against which to explore more ambitious consolidation strategies. It should also be kept in mind that the assumption understates the extent of required reforms as additional pressures on public spending from ageing populations are already assumed to be met by compensatory or offsetting budgetary savings...OECD general government net and gross debt is projected to increase by about 30% of GDP by 2011 relative to pre-crisis levels and, under the assumptions set out above, by about a further 20 percentage points of GDP before it stabilises thereafter. The number of OECD countries with gross debt levels that exceed 100% of GDP would rise from three prior to the crisis to eleven by the next decade...Current-account imbalances declined sharply during the crisis."

"A part of this current account improvement is likely to persist, as asset price bubbles that were fuelling the deficits in the United States and in several European countries have burst, translating into higher savings rates and/or lower investment rates in those countries, and as measures are being taken to prevent their reappearance. Fiscal consolidation in the large current-account-deficit countries, to the extent it exceeds that in the surplus countries, should also help limit the increase in global imbalances, at least in the short run. Another part of the recent narrowing of imbalances, however, was of a temporary nature and has already started to reverse. This reversal reflects the rebound in commodity prices and also the recovery in demand in large-deficit countries. The further unwinding of cyclical effects is also likely to lead to some increase in global imbalances. In particular, as all economies return to full capacity both the US trade deficit and the Chinese trade surplus are likely to increase. Thus, as the recovery continues and output gaps close, and in the absence of changes to policies that affect international imbalances, global current-account imbalances are set to continue to rise...On this basis, the baseline scenario foresees a widening of the US current-account deficit to about 4% of GDP by 2015 followed by a subsequent stabilisation, while the Chinese surplus as a percent of GDP would rise from about 4.0% in 2015 to about 5.50% in 2025. A recovery in oil and commodity prices would also bring about a rise in the current account surpluses of the main net oil-exporting countries. The net effect of the unwinding of cyclical factors and the effect of ageing populations imply a surplus in Japan of around 2-3% of GDP going into the next decade. The current-account balance of the euro area would stabilise at about 1% of GDP, although much bigger imbalances would remain within the area."

"In summary, under the baseline scenario of mild fiscal consolidation and otherwise unchanged policies, no significant rebalancing of growth should be expected and the overall scale of global external imbalances would edge slightly higher over the medium term albeit remaining below immediate pre-crisis levels...The baseline scenario implies the emergence of major imbalances which could sow the seeds of a future crisis...The risks of a disorderly unwinding of global current-account imbalances, including abrupt changes in exchange rates, would thus persist.... Although, by construction, government debt-to-GDP ratios are assumed to stabilise as a result of gradual consolidation measures, for many countries it is at greatly increased levels which is likely to imply higher long-term interest rates and dampen medium-term growth prospects. It will also leave many countries in a difficult position to cope with future shocks and the rising fiscal costs of ageing (which are not explicitly considered in the baseline)."

Is there a better alternative to muddling through that could produce a better outcome? In OECD's view, there is, but it would require "fiscal consolidation in OECD countries, exchange-rate realignments and structural reforms in most regions of the world. The recovery in those OECD countries where fiscal consolidation needs are greatest would be delayed (relative to the baseline scenario) because of the lags before structural reforms and exchange rate changes take effect, but GDP growth would remain positive in all major countries and continue to strengthen beyond 2012 so that output would catch up and exceed the baseline scenario after five years...Over the longer term, general government debt in most OECD countries would return to pre-crisis levels and measures of global current-account imbalances would be reduced relative to current levels. The flipside of the delayed recovery is that growth would be more sustainable over the longer run, whereas sustainability in the baseline scenario is highly questionable given the build-up in government debt and international imbalances."

But what are the chances that we will see the "fiscal consolidation in OECD countries, exchange-rate realignments and structural reforms in most regions of the world" that the OECD believes are required to put global demand back on a sustainable path? On the fiscal consolidation front, there is great debate over whether moves in this direction in the short-term are advisable, given the lack of any pickup in consumer spending (due to high unemployment and the uncertainty it causes, not to mention overleveraged balance sheets and falling home values) or in business investment (again, due to high uncertainty about future demand conditions and government policies). That leaves improved export growth as the remaining source of demand that, should it increase, would allow some reduction in government deficits. But it is a truism that, absent a sharp increase in import demand on Mars or some other planet, it is impossible for every nation on Earth to increase export growth at once. Yet there is no shortage today of countries that are pursuing exactly that strategy. Unfortunately, the most likely candidates for increasing imports seem, for a variety of reasons, to be opposed to going down that path. For example, Germany seems to prefer its traditional focus on exports as a driver of demand growth, instead of undertaking policy changes to stimulate domestic consumption (which German citizens, with their aversion to debt, might successfully resist) or higher levels of government deficit spending (which Germans might see as leading to higher taxes that, in effect, would force them to pay for the bailout of nations they see as less responsible than themselves).

But what about China, then? To begin with, rising tensions between China and the West on a number of fronts are unlikely to be accompanied by greater Chinese desire to help those same nations out of their current economic predicament (e.g., China's increasingly strong attempts to assert sovereignty over the South China Sea, its development of an antiship ballistic missile intended to limit the ability of the United States to use aircraft carriers to project force in Asia, and growing frustration among western businesses at the difficulty of doing business in China -- see, for example, "Global Economy: Trading Blows" in the 5Jul10 Financial Times). Yet that still leaves the question of whether domestic political demands could force the Chinese government to implement policies that would benefit the West.

To be sure, there are some glimmers of hope along these lines. For example, it is clear that a faction of the Chinese government recognizes that the economic crisis in China's traditional export markets means that, if social and political stability are to be preserved, China must transition to growth led by domestic consumption rather than exports and the investment spending needed to continuously increase them. Another example is the recent announcement that the Chinese government is exploring options to enable farmers to use their rights to use land (which they do not own) as collateral for obtaining loans. Economic history teaches us that this step can be an extremely powerful means of increasing agricultural productivity and income growth. Yet it also teaches that if there are not sufficient jobs in other sectors to absorb displaced agricultural workers, the results of this policy can be socially and politically destabilizing. And here is where the omens from China today are not good.

As Andy Xie writes ("China's Foul Assets, Fouler Yet", Caijing, 13May2010), "powerful interest groups have paralyzed China's macro policy, with ominous long-term consequences. Local governments consider high land prices their lifeline...[They] depend on the property sector for revenue as profits from [export] manufacturing decline and the need to spend [to meet growth targets and preserve social peace] increases...State-owned enterprises don't want interest rates to rise, as preferential lending treatment has led to their rapid expansion.... Exporters are suffering from rising costs and weak global demand. They are vehemently against currency appreciation. [China's leaders] have travelled the path of least immediate resistance -- monetary expansion and asset inflation...China's asset bubble has probably grown more quickly than any in the past...China's macro policies have been reduced to psychotherapy, relying on sound bites and small technical moves to scare speculators. In the meantime, inflation continues to pick up momentum."

Elsewhere, Michael Pettis (www.mpettis.com) has repeatedly shown why raising interest rates to slow the bubble economy is so difficult in China. Essentially, oppressing savers (and thus household consumption) by holding down rates is critical to the other players in the system, including banks (who need large funding gaps to offset the large number of bad loans they hold), state-owned enterprises (who need subsidized borrowing rates to offset the cost of maintaining overly high staffing levels to preserve political stability), exporters (for whom low borrowing costs helps to maintain competitive pricing in the face of slight exchange rate appreciation and intense price competition in their target markets) and state and local governments (which, as previously noted, have become critically dependent on property speculation for their revenues).

Pettis has further argued that, in addition to financial repression, holding wage growth below labor productivity growth has also been critical to Chinese competitiveness in export markets, which in turn drove job creation in those industries. With the effects of the one child policy now beginning to bite (in the form of a tightening supply of trained workers, and rising wage demands), minimizing exchange rate appreciation and continuing to hold down interest rates have become even more important to the maintenance of Chinese growth, and, in turn, social and political stability. Given these constraints on policy changes that would increase Chinese household consumption demand, Pettis concludes that "the world seems to be marching inexorably towards trade war" as "the U.S. will be forced to choose between either protection or soaring trade deficits and rising unemployment" ("The Last Chance to Avoid Trade War", Financial Times, 22Aug10).

Finally, there is the theory (hope might be a better word) that emerging markets besides China can provide the demand for increased exports from the West. Yet many of these countries have been pursuing the same export oriented, mercantilist strategy that China has, and appear to be just as unwilling to change their policies. There is also a more subtle problem at work. Were emerging market nations to suddenly switch from running current account surpluses to running substantial current account deficits (because of higher imports of goods and services exported by the developed nations of the West), the necessary counterpart would be surpluses on their capital account. These surpluses would be composed of a mix of increased foreign direct investment, loans from foreign banks, and issuance of equity and bonds by local companies to foreign investors. As we have noted in the past, there are serious questions as to whether the institutional structures in these nations (e.g., laws governing property, contract, and bankruptcy law, minority shareholder rights, disclosure, insider trading, etc.) are sufficiently robust to give foreign investors the degree of confidence needed to warrant a level of investment far greater than anything that has occurred in the past. Based on many years of experience in these markets, we believe that in most cases, they cannot meet this standard. It is one thing to allocate 10% of a portfolio to emerging markets. It is an altogether different thing to raise that allocation to 25% or 33%.

An excellent recent paper by Barry Bosworth and Susan Collins ("Rebalancing the US Economy in a Post-Crisis World", published by the Asian Development Bank Institute) evaluated the options facing the United States today, using the private-public-external balance framework that we have used for years in our analyses. They focus on "future challenges to external rebalancing from both the domestic and external perspective." They begin by noting that "for most of the past three decades, a growing trade deficit has been associated with a buoyant domestic economy, rapid job growth, and a decline in unemployment to unprecedented levels. This domestic strength suggests that the trade deficit was not something forced onto the United States economy by outside pressures, but rather a response to changing domestic economic conditions that pushed aggregate demand beyond the nation's productive capacity...The data show rising private consumption as the counterpart to a growing trade deficit." The authors then move on to a more specific examination of the determinants of America's external deficit. Historically, they show how U.S. imports have been relatively insensitive to changes in relative prices (i.e., exchange rates and relative inflation rates), and how U.S. imports have been "considerably more sensitive to changes in U.S. income than are U.S. exports to changes in the income of U.S. trading partners." However, Bosworth and Collins also show how all of these conditions appear to have improved over the past decade. However, they also highlight "a gradual secular decline in U.S. exports relative to imports in recent years, after controlling for changes in relative prices and incomes, as well as changes in the composition of U.S. exports and imports." They conclude that the most likely explanation of this finding is the relatively higher "willingness of American multinational firms to use the local production of foreign affiliates to serve foreign markets, as an alternative to exporting from the U.S." In the 22Aug10 Caijing, Xie echos this view, noting that "we are seeing the interplay between the forces of globalization and policy mistakes. Globalization has severely restricted the effectiveness of economic stimulus. The value of tade plus FDI are half of global GDP. Trade is visible in terms of stimulus leakage. But, where investment occurs in response to demand growth is far more important. [In a world of free trade and integrated global supply chains], multinationals can invest anywhere in the world in response to demand...Essentially, demand is local but supply is global...This cuts the linkage between demand stimulus and investment response. The latter is crucial to employment growth, which is necessary for sustaining demand growth [when the stimulus is reduced or withdrawn]."

Bosworth and Collins also note that, "exports, like private saving, are difficult to influence through available policy instruments, especially in the short-run." Looking at options for reducing domestic and external imbalances, Bosworth and Collins are pessimistic: "We conclude that additional fiscal stimulus, if unaccompanied by comparable fiscal stimulus by U.S. trading partners, would speed the recovery from the recession and promote job growth, but at the cost of an even larger budget deficit, a large deterioration in the trade deficit, and increased reliance on foreign financing. The result is financially unsustainable, and no simple means of correcting the future imbalances is evident...The absence of a clear path for the United States to escape the recession and emerge with a balanced economy is a cause for great concern."

With respect to the global rebalancing challenge, Martin Wolf accurately summed up our view of the current situation in the title of a recent column: "This Global Game of Pass the Parcel Cannot End Well" (Financial Times, 29June10).

There are also substantial domestic challenges to aggregate demand growth in most developed countries today. Briefly, the household sector is still burdened by historically high debt levels, falling residential property values, and fears of higher unemployment. While spending by the highest income groups appeared to have picked up earlier this year (the top five percent of households by income account for about 33% of U.S. private consumption spending), this has recently turned down (see "Wealthy Reduce Buying in Blow to the Recovery", Wall Street Journal, 16Jul10). Private sector investment is held back by uncertainty regarding future demand growth, by lack of credit (particularly for bank dependent small businesses), and in some cases (most notably the U.S.) by high uncertainty about future changes to government taxes and regulations (for an interesting research paper on this, see "Do Powerful Politicians Cause Corporate Downsizing?" by Cohen, Coval and Malloy). Finally, continued deficit spending by governments is increasingly constrained by rising concern over mounting levels of debt.

As some commentators have noted, while there has been considerable use of monetary and fiscal tools to stimulate the U.S. economy, to some extent these policies may have been based on faulty diagnosis of the underlying problem. PIMCO's Mohamed El-Eiran noted recently ("Why Another Fiscal Stimulus Won't Do", Washington Post, 27Aug10), "what is critical to keep in mind is that this situation is part of a broad, multi-year process driven by national and global realignments. It's a secular phenomenon that needs to be better understood and navigated, by recognizing its structural dimensions and by urgently broadening the excessively cyclical policy mindsets that abound. Unfortunately, the approach in too many industrial countries has been to kick the can down the road, seemingly hoping for a series of immaculate economic recoveries. Policymakers must break this active inertia by implementing a structural vision to accompany their current cyclical focus." This is a point we also have frequently made in our writing, focusing on the need for structural reform in critical areas like public education, small business finance, energy policy, social safety net programs, health care, financial sector reform, and reducing household debt burdens. However, El-Erian is not optimistic that we will see an increased focus on structural rather than cyclical policies: "To my dismay, the prospects for a sufficiently bold policy reaction are doubtful...The politics of structural change are an impediment to recovery...An already polarized political environment is becoming even more fractured by far less substantive issues. There is virtually no political center that can anchor consensus and enable sustained implementation of policy." Sadly (and we write this having once worked in a Washington where the center ruled), we have to agree with El-Erian on this critical point, and with his final conclusion that "this worrisome trio of increasingly ineffective national and global policy stances, intense political polarization, and growing social pressures speaks to the risk that the economy’s recent soft patch will evolve into something even more troublesome and sinister."

Next Month: Assessing the Risks to Political Legitimacy

| Product and Strategy Notes: New Products (CBOE - Skew Index), Citi's CLX, UK JP Morgan UCITS; New Research for Advisers and Investors; Implications of the Borg | Table: Fundamental Asset Class Valuation and Recent Return Momentum | August 2010 Issue: Key Points | This Month's Letters to the Editor: Who Would You Invite to Dinner?; How Should One Evaluate II's Asset Class Valuation and Economic Updates?; How Did You Identify the Three Regimes You Use in Your Analysis - High Inflation, High Uncertainty and Normal Times? | August 2010 Economic Update: Too Much Leverage and Too Little Demand | Investor Herding Risk Analysis | Overview of Our Valuation Methodology | Uncorrelated Alpha Strategies Detail | Feature Article: The Risk of Deflation and Its Impact on Asset Class Returns | Global Asset Class Returns | Table: Market Implied Regime Expectations and Three Year Return Forecast | Global Asset Class Valuation Updates Detail through July 30, 2010 |