Global Macro blogby Karl Martin Lind

Exactly one year ago I landed in New York to co-host a training seminar for my central bank clients and prospects. They came from all over the world to New York and over the following days we watched the world economy as it hurtled into an economic vortex; economic growth in many advanced economies in free-fall reminiscent of the Great Depression.

Yet as of this writing, the situation looks very different, growth in advanced economies are bottoming out and several emerging economies are picking up steam.

The situation leaves some open questions as to the future outlook on growth. What will long-term growth look like, and do we risk a relapse into another recession?

Currently the debate is between those who expect a classical V-shaped recovery with a rapid return to trendline growth and those (still a minority) – like myself – who believe it will be U or W-shaped, weak and below trend for a number of years, after an initial few quarters of strong growth driven by inventory restocking and as production picks up from near record low levels.

There are several reasons why growth in the US, the UK, Japan and much of Europe will remain weak, but three stands out as the most important.

First, consumers are highly leveraged and both unwilling, and unable to take on more debt. Households and parts of the corporate sector are now forced to rebuild their balance sheets by cutting expenses, save and pay down debt, with the most obvious effect of a rapidly rising savings rate. This is both negative for growth and highly deflationary. With a 1% annual increase in the savings rate over the next 10 years (as opposed to the 0.5% decrease over the preceding 25 years) this alone shaves off 1.5% from the “old” trendline growth of 3.5%. Growth will therefore remain sluggish until the debt and servicing ratios improve considerably from today’s levels.

Second, the releveraging of the public sector through large fiscal deficits will saddle the federal budget with huge interest expenses and crowd out private investment. US national debt is now over 11.8 trillion, representing 380 billion in interest expenses, around half of it paid to foreigners. The administration expects to add a further 9 trillion in debt over the coming 10 years. Assuming the same (generous) interest rate and an optimistic 3% annual GDP growth, it puts the interest expense alone to over one third of the federal budget, up from the current 25%.

Third, deflation. We are currently living in a highly deflationary environment, and I believe had it not been for the Fed’s printing presses the US would have felt its full force. “Bad” deflation puts pressure on corporate margins, it puts off spending, it encourages saving and leads the economy into a negative feedback loop of lower growth. For an economy saddled with debt and lacklustre growth, deflation is the worst of all worlds. Expect the Fed to continue its inflationary policy until we see the velocity of money start picking up.

The second issue is the shape of the recovery and whether we risk a “double-dip” recession. Herein, lies the question of the exit-strategy and where policymakers face some very though choices. If on one hand they take large deficits seriously and reduce the fiscal and monetary stimulus too quickly, the economy will stall and fall back into deflation and recession – stag-deflation.

If, on the other hand, they maintain large fiscal deficits and continue to pump the system full of dollar, investors will sooner or later expect inflation to pick up. This will force a bond market sell-off, pushing borrowing rates higher, stoking the economy and push it into stagflation.

I am afraid there are no good solutions to this problem, only less bad ones. Repairing the sovereign balance sheet will require years of austerity, a credible plan for the return to fiscal discipline and painful increases in taxation. Although sub-optimal in a post-recessionary economy, the >100% debt/GDP ratio forecast for the middle of the next decade would likely prove even less so.

If they do not control spending, the country will risk running up a debt that becomes very difficult to finance by conventional means – even monetization can only work for so much!

In summary, the US economic recovery is likely to be brisk in the second half, then taper off, with risk of another recession, before returning to “European style” real-GDP growth of around 2% per annum.


Karl M. Lind

Oslo, 14 September 2009