October 2009 Economic Update

As long-time readers know, over the years we have found the Economic Balance Identity (EBI) to be a particularly useful framework for generating insights about the state of the global economy, and what lies ahead for asset class returns (for an excellent recent overview of this approach, see "Fiscal Policy and the Economics of Financial Balances" by Gennaro Zezza). The EBI is composed of three key terms. The first is the private sector balance. This represents the excess of savings over investment in the private sector. Savings are the difference between total output and private consumption, and investment includes capital spending by both households and businesses. The second key term is the public sector balance, which is the difference between taxes and other revenues, and total public sector spending. The third key term is the external, or current account balance, which is the difference between the goods and services a nation imports, and those it exports to other countries. By definition, the sum of a nation's private and public sector balances equals its external balance. Another critical point about the EBI is that it measures flows over a given period of time. Some of these flows represent real demand for goods and services. However, any imbalance on the private, public or external account also gives rise to a flow of financial claims. For example, for part of the past decade, the United States' private sector balance was negative, with the excess of consumption and investment over output financed via the issuance of claims on the private sector's future real output, whether in the form of debt or equity instruments. Similarly, for most of the past decade, the United States public sector balance was also negative, and was financed by the issuance of various types of government debt (i.e., claims on future tax revenues) by federal, state and local authorities. Finally, the sum of the United States' private and public sector balance was also negative for most of the past decade, which meant that the current account balance was also negative, and financed by the issuance of private and public claims to investors located in other countries (e.g., China). In other countries, the opposite situation prevailed, with positive private sector and current account EBI balances leading to the accumulation of financial claims.

Those of you with a systems dynamics bent have no doubt already recognized the next point: while the EBI measures the flows in the system over a given period of time, those flows also affect the levels of different stocks that can place constraints on the systems overall level of performance. On the real side of the economy, these potential supply constraints include the supply of raw materials, skilled labor, and existing productive capacity. On the financial side of the economy, the key constraint is the willingness of parties with positive private, public or current account balances to continue to accumulating debt and equity claims issued by parties with negative balances.

It is with these concepts in mind that we reviewed the statistical tables that are published each year with the IMF's World Economic Outlook. As always, they told a very sobering story, which we will summarize here. To set the scene, the following table shows the percentage of world GDP that is accounted for by various countries and regions:

As you can see from this table, the world is evolving towards two main economic constellations, the Anglosphere countries and a slowly organizing group of nations in Asia (and in this context, the recent call by newly elected Japanese prime minister Haotyama for the formation of an Asian economic bloc, similar to the European Union, is a sign of the times). Economically, the most important groupings on the periphery of these two core constellations include the Eurozone and closely associated countries, the Middle East, and Brazil and Russia.

Let us now turn to the changes in key private, public, and current account balances between 2007 and 2010 (the latter as forecast by the IMF), with all data expressed as a percentage of world GDP. The following table presents this analysis:

This table clearly shows the dramatic and jarring changes that have occurred in the world economy (keep in mind that each 0.1 percent change between 2007 and 2010 as a percent of world GDP is worth about USD 70 billion, based on the average size of world GDP over this period - and a 1.0% change is worth about 700 billion). To begin with, the Anglosphere private sector balance went from negative (.61) percent of world GDP to 1.91% -- a swing of 2.52%. This represents nearly two trillion dollars that was previously spent on private consumption and investment that is now spent on debt repayment or savings (i.e., the accumulation of financial claims issued by parties with negative balances). This change - in no small measure caused by reluctance of other parties to further add to their stock of financial claims on the future output of the Anglosphere private sector - represents an enormous shock to global aggregate demand. Consider what would have happened if the Anglosphere public sector balance had remained at its 2007 level of negative (.63). The EBI makes it clear that the Anglosphere's external balance would have become a positive 1.28% of world GDP. Of course, this raises the question of how this would have affected those countries that had previously run positive current account balances that were the necessary offset to the Anglosphere's previous deficit. Of these, the two most important were China (1.18%) and the Middle East (.71%). Had there been no change in either their own private sector balance or the public sector balance of the Anglosphere, both of these regions would have experienced dramatic reductions in aggregate demand, probably with severe social and political consequences.

It is therefore very interesting to see how events actually turned out, in terms of changes in the EBI. As you can see, a substantial portion of the potential external impact of the swing in the Anglosphere's private balance was offset by a dramatic increase in its public sector deficit. Of the external impact that remained, most of it was absorbed by the Middle East, via falling oil prices, (.31) and Japan (.20). The Eurozone (.09) and China (.08) suffered comparatively smaller shocks to their net export demand. To put it differently, it appears from the data that over the past two years, the U.S. taxpayers, via their future obligation for service on U.S. federal debt, have spent a very substantial amount of money (e.g., the expansion of the U.S. public deficit was more than three times as great as the expansion of China's) to ensure short term economic, social and political stability in China, presumably with the intention that this additional breathing room will be used by the Chinese to accelerate that country's transition to an economy driven much more by domestic consumption demand (and hence a potentially a bigger market for foreign exports), and much less by investment and export demand. Time will tell whether this is the case (though as we note below, we have our doubts).

However, in every country with the exception of Switzerland, there was a significant positive increase in the private sector balance that was offset, to some degree, by an increase in the negative public sector balance in an attempt to maintain aggregate demand. On the monetary side of the world economy, governments also undertook multiple initiatives to maintain the functioning of the global market for financial claims, particularly those on private sector issuers, and thereby avoid widespread bankruptcies and accelerating deflation. In aggregate, these policy initiatives have resulted in an unprecedented increase in the global money supply.

So this is the predicament we are in today. An inherently unstable system in which global demand was sustained the continued willingness of the Middle East and China to accumulate financial claims on the Anglosphere's household and business sectors has given way to one which demand is sustained by the continued willingness of investors to accept financial claims on governments' future tax revenues. It would appear that we have traded one debt financed boom for what may turn out to be another. The difference, of course, lies in the way these two different types of booms historically come to an end. In the case of excessive private sector debt, the collapse of the bubble that is often its final chapter triggers widespread bankruptcies, and a collapse in demand, asset values and prices that has been called debt deflation. However, in the case of excessive public sector debt, the collapse usually takes the form of high inflation and a dramatic fall in the exchange rate. To be sure, the speed with which these end games play out varies substantially from episode to episode. For example, Japan has struggled for two decades with the aftermath of the collapse of its late eighties bubble, while during this same period Argentina has arguably gone through this process at least twice.

This raises the question of what, if any, alternatives there are to repeating the experiences of these two countries. As Reinhart and Rogoff note in their new book (This Time is Different: Eight Centuries of Financial Folly), history is not encouraging in this regard - banking crises usually result in prolonged periods of reduced economic demand and output. As a number of thoughtful analysts have recently noted (see, for example, Bill White's OpEd "Some Fires are Best Left to Burn Out" Financial Times 16 Sep 09, and Andy Xie's column in the 16 Sep 09 issue of Caijing, "What We Can Learn as Japan's Economy Sinks"), our best alternative may be to aggressively pursue structural reforms on the supply side at the same time we provide fiscal stimulus via a widening public sector balance to maintain demand. Three structural reforms seem critical. The first is a controlled reduction in the levels of debt that cripple the financial sector in the Anglosphere and parts of the Eurozone. We have repeatedly stated our belief (based on experience twenty five years ago in Latin America) that this can be accomplished through a mix of bankruptcies, debt/equity swaps and selective government support. This will also help to reduce excess capacity in industries where its continuation would result in prolonged downward pressure on prices.

The second critical reform encompasses a range of measures that will help to increase productivity, economic growth, and the private and public sectors' ability to service their debts in the future while still achieving rising standards of living. These measures include investments in improved physical infrastructure (e.g., smart Grid) and reforms that increase the efficiency and effectiveness of healthcare and educational systems. Given the scale of the overcapacity that has developed in many industries, and the increasingly uncertain and volatile nature of an integrated world economy, these measures should also include (particularly in the United States) a more effective and efficient system for supporting people facing prolonged periods of unemployment.

The third critical reform is a significant appreciation in China's exchange rate. As Bill Emmott notes in his 21Sep09 London Times OpEd ("Time to Stop Being Chicken and Talk About China"), this will do more than any other policy step (short of a sharp increase in protectionism) to wean China from its aggressive mercantilist economic strategy (which is now effectively exporting unemployment to other countries, in a worrying echo of the 1930s), and force it to devote more effort to building domestic demand. To be sure, this is already happening (e.g., in a 7Oct09 Financial Times column, James Kynge provides some very important evidence about the monetization of agricultural land and the "Seeds of Change in Rural China.") But as many others have noted, the increase in domestic Chinese demand is not happening fast enough, given the challenges facing the rest of the world (see Martin Wolf's 22Sep09 Financial Times column, "Why China Must Do More to Rebalance Its Economy"). The longer this change is delayed, the worse the consequences are likely to be. As Xie notes in his article, "as I traveled across China recently, it was rare to hear about a business whose officials are enthusiastic about their core business. But everyone seems excited about financial activities. The lending boom in the first half of 2009 seems to have been channeled mostly into asset markets by the corporate sector. In particular, property seems to have become the main source of profit for most big businesses...If a manufacturing business is buoyant, odds are it is profiting from property development...China's corporate sector increasingly looks like a shadow banking system. The same thing happened in Japan."

Yet as noted in many of the articles published on the recent 60th anniversary of the founding of the People's Republic, the current Chinese leadership is caught between their worries about the economic future, and their even greater worries about social and economic stability over the next three months, which, they believe would be threatened by a sharp shift away from China's current orientation towards investment and exports as the main motors of aggregate demand. Further evidence of this was recently provided by the Telegraph, in a story about the draft "Rare Earths Industry Development Plan 2009-2015." With rare earths metals critical to many industries (e.g., hybrid vehicles and wind turbines), and with China having driven most other world producers out of business (via cheaper labor, capital, energy and environmental costs), the report allegedly called for a total ban on shipments to foreign suppliers, to provide a greater advantage to Chinese producers making use of these materials. While the final plan has yet to be officially released, it is undeniable that Chinese exports of these materials have been severely reduced in recent years, and that China has recently targeted cleantech sectors making use of rare earth metals as a priority for future development (see The China Greentech Report, 2009). In this regard, another recent publication also makes fascinating reading, despite the fact that we don't agree with all of it. "China's Strategic Culture: A Perspective for the United States" is a monograph published by the Strategic Studies Institute of the U.S. Army War College, authored by a career intelligence officer, Colonel Kenneth Johnson. The paper "illustrates the key characteristics of Chinese strategic culture - philosophy, history and domestic factors that, to a remarkable extent, structure the strategic objectives of China's formal foreign policy and explain how Chinese strategic interests are defined by modern Chinese pragmatic nationalism, its drive for modernization, and the desire for China to have a more prominent role in the Asian and world communities." Johnson concludes that "the main goal of Chinese foreign policy is to maintain a strong, independent, powerful and united China that can pursue its number one priority: economic development." That said, that author also notes the historical Chinese preference for an active defense, and a willingness to take preemptive action when threatened. In that regard, it was also interesting to read Stratfor.com's recent analysis, "The China Files: The Core Struggle", which frames the current domestic tensions in China in the context of the repeating conflicts throughout Chinese history between the central government and provincial bureaucrats, and the inward looking peasant interior and the outer looking coastal economic elites. Together, these analyses reinforce our belief that it is unlikely that China will acquiesce to the appreciation of its exchange rate versus the U.S. dollar, or to any reforms in its capital intensive export industries that would result in a sharp increase in unemployment. While the recent G-20 meeting in Pittsburgh paid lip service to the need for global rebalancing, the fact remains that there exists no mechanism to compel such adjustment. Unfortunately, the alternatives are equally unpalatable: a sharp rise in protectionism (which China could easily interpret as a threat to its national security) or prolonged stagnation in the Anglosphere and Eurozone economies. In short, there does not appear to be an easy way out of the trap we are in, though moving aggressively on the other two structural reform priorities would likely help - perhaps substantially.

Elsewhere last month, the IMF's most recent Global Financial Stability Review made is clear that the global financial system still faces serious challenges. "The risk of a reintensification of the adverse feedback loop between the real and financial sectors remains significant as long as banks remain under strain and households and financial institutions need to reduce leverage...there are still serious concerns that credit deterioration will continue to put pressure on banks’ balance sheets...the transfer of financial risks to fiscal authorities, combined with the financing burden of fiscal stimulus, has raised concerns over crowding out the private sector and the sustainability of public sector finances." The GSFR forecasts that another $1.5 trillion in writedowns will have to be taken, and "earnings are not expected to fully offset them over the next 18 months, resulting in continuing pressure on capital." In this regard, another article caught our eye last month: "Homeowners Who Strategically Default on Loans a Growing Problem", which was published in the 20 Sep 09 Los Angeles Times. The article described the results of a new study by Experian and Oliver Wyman, that found a surprisingly high and rising number of so-called "strategic mortgage defaults" by U.S. homeowners with high levels of income and education, good credit scores and spotless payment records. "Two thirds of these defaulters were walking away from primary homes" and "look at defaulting [on the mortgage on a house with substantial negative equity] as a business decision...they see it as the most practical solution under the circumstances." We prefer to see this report in a larger context, in which the strategic defaulters have assessed the likelihood that their economic situation will improve within a reasonable period of time - i.e., the price their house will go up, and their risk of unemployment will go down. As we have repeatedly noted, implementation of the three structural initiatives we believe are critical to sustained economic recovery are all currently blocked by powerful interest groups. Making the situation even worse, potentially, is the growing political opposition to further increases in government deficits. In short, what the Soviet's used to call "the correlation of forces" increasingly seems to favor a prolonged period of economic stagnation. In this context, we are not surprised that "strategic defaults" by the most educated mortgage borrowers are increasing, as they decide to cut their losses in the face of what they have concluded is the most likely future scenario.

Last but not least, last month saw a further worsening in the growing crisis between Iran and the West. Shortly before the G-20 meeting, the leaders of the United States, United Kingdom and France announced the existence of a second fortified nuclear enrichment facility near Qom. This was after President Ahamdinejad made a vehemently anti-Israel speech at the United Nations. Then right after the G-20 meeting, the New York Times reported that the International Atomic Energy Agency had concluded that the Iranians were now capable of building an atomic bomb, while the London Times reported that Israel had informed Russia that it was aware of the latter's heretofore unacknowledged and apparently extensive support for Iran's nuclear program. To complete the flow of bad news, Stratfor.com published an excellent analysis showing how Russia and its Central Asian allies could enable Iran to avoid any negative impact from the "crippling" gasoline import sanctions promised by the Obama administration if Iran did not halt its nuclear program, and the Iranian courts pronounced the first two death sentences on people arrested during this summer's post-election protests. If the current course is not altered, it seems inevitable that either Israel and/or some combination of Western nations will militarily attack Iran, as the traditional theory of nuclear deterrence seems rather shaky in its application to parties with extreme religious beliefs. Any military attack would likely lead to the mining by Iran of the Strait of Hormuz, which would cause a sharp spike in oil prices and create severe headwinds for governments' attempt to maintain aggregate demand through fiscal and monetary stimulus.

In sum, developments over the past month do not seem consistent with the development of our cooperative scenario. (For more detail on key scenario-related evidence accumulated over the past three months, please see the Appendix found in our pdf versions).

| October 2009 Issue: Key Points | Global Asset Class Returns | Uncorrelated Alpha Strategies Detail | Table: Market Implied Regime Expectations and Three Year Return Forecast | Table: One Year Asset Class Valuation Conclusions and Recent Momentum | Market Phase Change Risk Analysis | This Month's Letters to the Editor: Oil and Gas Partnerships - Do they fit in your portfolio?; What's the best Asset Allocation Today; Is it Possible to Over-diversify a Portfolio?; PIMCO Heavy Weighting for Emerging Markets, II's thoughts?; Timber Followup | October 2009 Economic Update | Global Asset Class Valuation Updates Detail | Feature Article: Equal Risk Weighted Portfolios in 2007 and 2008 | Product and Strategy Notes: Challenges Facing Investors in Venture Capital Funds; Improving Warning of Future Financial Crises; A New View on the Fundamental Drivers of Equity Market Returns; and The Long-Term Impact of the 2007-2008 Crisis on Financial Advisers' Compensation |