Executive director/Chief analyst of ECR Research Edward Markus is co-author of this blog
Credit contraction
Many of the challenges facing President Obama in his second term have their origins in massive debt. From 1980 up to 2007 there was an explosion in debt that was used for financing consumption and buying homes. Consequentially, economic growth increased sharply and housing prices rose. Rising property prices made it possible to borrow more, so the economy grew even more rapidly, stock prices rose, and so forth.
However, in 2007 the credit crisis brought an abrupt end to all this. Stocks and housing prices fell and banks were confronted with high losses. As a result, they lent less, putting stocks and property prices and the economy under even further pressure.
Central banks and governments to the rescue
Without central bank and government intervention the economy would certainly have ended up in a deep depression. The Fed lowered short-term interest rates to virtually 0% and purchased government bonds on a grand scale. The idea was to suppress long-term interest rates and boost riskier asset prices. That improved consumers' balance sheets. It was hoped that, combined with low interest rates, that would lead to consumers starting borrowing again.
While consumers were attempting to repay their debts, the government was actually increasing its own. That helped temper the decline in consumer spending.
Central banks and governments were hoping this strategy would give consumers more confidence and start a new phase of credit expansion. The resulting higher growth then had to be used to reduce public debt.
False hope
Some analysts claim the percentage of consumer salaries spent on interest and repayments obligations has dropped considerably and consumers will shortly start borrowing again. That is a wrong prediction for a number of reasons.
First of all, due to demographic changes. The average age of baby boomers is now 56. From the age of 55 people save more. That can certainly be expected now, as retirement provisions are generally badly organized and life expectancy has been increasing.
Secondly, since 1997, a couple of times already, most consumers have seen asset prices rising to the sky, only to drop sharply afterwards. Consequentially, consumers will first want to see stocks and housing prices rising for some time before deciding to borrow more.
Thirdly, much of the reduction in debts has been caused by bankruptcies (chiefly foreclosures). Those people will not be able to obtain credit for the time being.
Deficits prohibit more stimulus
To summarize, there will be little sign of new consumer borrowing. Therefore, the government will have to go on increasing its deficits for some time. The trouble is, though, that public finances are in a poor state and due to the aging population government expenditures on healthcare and social support will soar.
Budget deficits should be seriously reduced. Otherwise, investors will only lend to the government at higher interest rates. Higher interest rates would be disastrous for public finances. In short, the government can no longer continue compensating for deleveraging in the private sector.
There is yet another problem: it becomes increasingly difficult to boost asset prices. That requires ever-more money creation. However, so much extra money has now been created that it entails enormous risks. The result could be not only higher stock prices, but also rising commodity prices. That slows economic growth. But aside from that, as soon as extra credit activity has been achieved, there is immediately a high risk of inflation and thus higher interest rates. In other words, monetary policy is reaching the end of its effectiveness.
Hard times ahead
Nor consumers, nor governments, nor central bankers will be able to get the economy going again. Unemployment remains dangerously high, especially if you allow for the fact that many members of the labor force are discouraged from seeking work. It is therefore understandable that wages are rising so slowly that real disposable incomes are falling. That is reflected in the fact that the number of hours worked is steadily declining.
For the time being, the economy will remain extremely vulnerable to any setbacks. The Fed has announced that it is prepared to keep the liquidity taps open until unemployment has dropped substantially. Moreover, the ECB and the Japanese and Chinese central banks are expected to further stimulate their economies. That should generate a highly positive climate for stock prices. However, that has not been the case for a number of weeks already, and most markets have even reached crucial support levels. If they fall through them, then consumer confidence will quickly wane. After all, it is then evident that fiscal and monetary authorities are no longer capable of maintaining the level of growth and that central banks have merely been creating bubbles. The US economy then threatens to become a rudderless ship.