Friday, November 15, 2013

Can the United States pull off a beautiful deleveraging?

As Ray Dalio points out in a recent video, "borrowers debt levels have simply gotten too big and can't be relieved by lowering interest rates", he explains that there are several ways to tackle a deleveraging which has to occur once we reach this point (cut spending, reduce debt, redistribute wealth & print money):

Dalio's video suggests that in a 'beautiful deleveraging' it takes a decade or more for debt burdens to fall and economic activity to get back to normal (2-3 years of deleveraging/depression, followed by 7-10 years of reflation).

Others believe that the deleveraging will occur over longer period of time, for example David Llewellyn-Smith of MacroBusiness recently wrote:
The GFC was and is the pivot point in a structural adjustment that has only just begun, probably has decades yet to run, and before it’s over will likely change our world to something that looks more like the nineteenth century than our super fast modern version (in the sense of slower moving capital not widespread typhous!).

Put simply, we’re in a long term deleveraging phase for the global economy following a long term leveraging phase. What this means is that pretty much for the rest of your working life, the world is going to be regularly convulsed as its debts are saved against, inflated away, defaulted upon, and even sometimes repaid! It will shake both private and public sectors repeatedly and will afflict both developed and developing economies.

This is neither good nor bad. It is neither bearish nor bullish. It just is.
My response to this post, in the comments below was:
The view that we will see decades worth of readjustment makes the assumption that we don’t see a major event (planned or unplanned) change the entire financial / monetary system as we know it. It makes the assumption that after half a century of imbalances building we will be able to rebalance slowly, but surely, with only the odd crisis to contend with (none of which will spin out of control resulting in a larger collapse or a change to the status quo). I simply don’t buy it.
I think it's very unlikely that the US (or in fact many western economies which have a high level of debt to GDP) will be able to delever so easily this time around. US total credit market debt to GDP is down from the 2009 peak, however has a long way to fall before returning to levels that could be considered sustainable if interest rates were to normalise:

In 1933 US total debt credit market GDP topped at 300% (assisted by a 46% decline in GDP starting in 1929) and took roughly 20 years to bottom:
At the beginning of the Great Depression in 1929, the bulk of US debt was corporate debt tied to the investment bubble in auto manufacturing, electric utilities, household appliances, radio and other sectors that made up the "new economy" of the Roaring Twenties. Corporate debt to GDP collapsed from over 100% in 1933 to under 30% by the mid-1940s. Household debt fell from 50% of GDP in 1933 to roughly 15% in the same time period. Much of the drop in total debt to GDP came during the 1933-1936 period, when the dollar was devalued by 50% and economic growth was very high (albeit from an extremely low base). The ratio rose again when the economy relapsed in 1937-38, but resumed its decline when the economy recovered modestly in the pre-war years. The Dynamist
Today, the US is in an even more precarious position than during The Great Depression. The level of debt to GDP is much higher and more importantly the US is not able to easily devalue the dollar as they did in 1933 when they adjusted the Gold price from $20.67 per ounce to $35 per ounce.

Many other countries left the Gold standard in the 1930's in order to devalue their currencies along with the US. It's not so easy today, the US isn't able to devalue their currency against a reserve asset like Gold as their currency is the defacto global reserve currency. They are only able to compete with other countries to devalue their currency all the while putting on the facade that they have a "strong dollar policy".

The US faces the challenge of trying to reduce their debt burden at the same time as receiving criticism from China and elsewhere over attempts to kick start economic growth & inflation to reduce their massive debt burden (the below just one example of many where they have been criticised for their actions):
A senior Chinese official said on Friday that the United States should cut back on printing money to stimulate its economy if the world is to have confidence in the dollar.

Asked whether he was worried about the dollar, the chairman of China's sovereign wealth fund, the China Investment Corporation, Jin Liqun, told the World Economic Forum in Davos: "I am a little bit worried."

Jin said he was confident that the Obama administration and Congress would ultimately solve the debate over the so-called fiscal cliff, "but of course the printing machine will have to slow down for people to have full confidence in the dollar". Jan 2013, Reuters
It seems to me that the US faces an impossible situation, as they attempt to reduce their significant debt burden, while retaining the US dollar as global reserve currency, a luxury which has allowed them to over spend as long as they have.

It seems to me what the US and the rest of the world could do with is a global reserve asset against which to devalue fiat currencies & extinguish their debt.

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