September 26, 2011
It was Gary Shilling – way back in the last century – who first woke me up to the real whys and wherefores of deflation, with his 1998 best-seller, Deflation: Why it’s coming, whether it’s good or bad, and how it will affect your investments, business, and personal affairs. I had read various works on deflation, but nowhere was it put together as well as Gary did it. He followed it up the next year with Deflation: How to survive and thrive in the coming wave of deflation, and in that one he strongly urged his readers out of the stock market – just ahead of the 2000 dot-com bubble burst. But Gary has been so right over the past three decades. (He recently updated Deflation with The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation. It’s on Amazon at http://www.amazon.com/Age-Deleveraging.
Today’s Outside the Box is a condensed version of Gary’s monthly INSIGHT newsletter, and in this one he tackles the lack of effectiveness of the Fed’s QE1 and QE2 and delves into the “strange things [that] happen in security, currency and commodity markets that don’t fit normal rules” when the Fed and other central banks take interest rates down close to zero. He notes that at the same time QE2 was fomenting a global commodity bubble and stock-market advances through 2010 and into early 2011, it was also punishing lower-income households with higher food and energy costs, and saddling them with falling home prices “that are likely to drop another 20%.” Crucially, the Fed is “pushing on a string” that, with “the depth and breadth of the financial crisis, the collapse in housing, the ongoing sovereign debt crisis in Europe, Japan’s continuing two-decade-old deflationary depression, the impending hard landing in China, etc. make the monetary policy string much more limp than usual.”
Picking up a theme from his most recent book, The Age of Deleveraging, Gary also examines the question of whether the US is headed for a deflationary depression like the one that has beset Japan for more than two decades. I won’t spill the beans on his conclusion here, but let’s just say that we have our work cut out for us.
If you appreciate Gary’s lucid analysis and want to subscribe to INSIGHT, be sure to mention Outside the Box, and you’ll get 13 issues for the price of 12, PLUS their January 2011 report in which Gary lays out his investment strategies for the year. The price via email is $275, and the address is email@example.com, or you can call them at 1-888-346-7444.
Your loving London but lusting for Ireland analyst,
John Mauldin, Editor
Outside the Box
(excerpted from the September 2011 edition of A. Gary Shilling’s INSIGHT)
In its written release after its August 9 Federal Open Market Committee policy meeting, the Fed included a statement that was highly unusual because of its specificity. “The Committee currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through mid 2013.”
In the recent past, the Fed has stated its plans to keep rates low for an “extended period,” but we can’t recall the central bank ever being this precise on any policy. The statement was also significant because it means that unless the economy takes off like a scalded dog, the overnight federal funds rate will continue close to zero, its absolute bottom. Not surprisingly, longer term Treasury rates dropped on the announcement. The 2-year note yield fell to 0.185%, an all-time low, and the 10-year note yield hit 2.033%, below the previous 2.034% low reached on Dec. 18, 2008, after the collapse of Lehman Brothers drove investors to the safe haven of Treasurys.
The Fed is not alone in keeping central bank short-term rates close to zero (Chart 1) in response to sluggish and declining global economic growth and the inability of massive monetary and fiscal stimuli to revive economic activity. The outlier among major central banks is the ever-inflation wary European Central Bank, the spiritual descendant of the German Bundesbank and based in Frankfurt, Germany, for good reason. The ECB raised its target rate in April and again in July to 1.5% in response to Eurozone consumer inflation above its 2% annual rate target for the overall index. Nevertheless, ECB President Trichet apparently has put further increases on hold and may later cut its rate in response to unfolding weakness and persistent financial turmoil in Europe.
Zero interest rates are significant for several reasons. Zero is the floor below which rates normally don’t fall, although the 3-month Treasury bill rate recently was negative amidst investors’ mad rush for liquidity and the safe haven of government paper. More importantly, at zero interest rates, strange things happen in security, currency and commodity markets that don’t fit normal rules. This doesn’t mean that actions are illogical and don’t follow rational behavior, but rather that the rules of difference. Most observers don’t understand thoroughly the new norms, their causes and effects. Most significantly, central bankers and fiscal policy managers don’t seem to either, which makes forecasting the outcome of their actions and the unintended consequences extremely difficult.
How We Got Here
You’ll probably recall how the Fed got to its current federal funds target of 0-0.25%. In early 2007, the subprime residential mortgage market started to fall apart. By August, the Fed had cut its discount rate and the federal funds target rate shortly thereafter, initiating the declines that resulted in the current levels.
In 2008-2010, in what became known as QE1, the Fed bought $300 billion in Treasurys, $1.25 billion in residential mortgage- related securities and $100 billion in Fannie Mae and Freddie Mac securities in an attempt to further prop up the faltering housing market and reduce mortgage rates. But these efforts were of little aid to the housing market, and prices resumed their decline in mid-2010 after the effects of the tax credits for new home buyers expired. So, in August 2010, Fed Chairman Bernanke hinted at QE2, which was implemented in late 2010, ran through mid-2011 and initiated the purchase of a net additional $600 billion in Treasurys.
No Follow-On Effects
Like QE1, QE2 did put money in the hands of investors in return for Treasurys, but had no follow-on effects. As we’ve discussed repeatedly in past Insights, the Fed creates reserves by buying Treasurys and other securities. It doesn’t print money, as the media insists, except for paper currency to satisfy public demand. It requires the cooperation of the banks as lenders and the creditworthy borrowers to turn those reserves into loans and money. But banks and borrowers have been reluctant to do so and excess reserves over and above reserve requirements now total about $1.6 trillion. Nonfinancial businesses have more than ample cash and little desire to borrow. Creditworthy individuals are also reluctant to borrow, and instead are paying down their mortgage and other debts.
With QE2, the Fed did not achieve its goal of reducing mortgage rates further to aid distressed homeowners. When Fed Chairman Bernanke hinted at QE2 last August, 30-year fixed rate mortgage rates did fall along with 10-year Treasury note yields to which they are linked, but then rose when the program was finally announced in November. Was this a classic case of buy the rumor, sell the news?
The central bank did, however, succeed in staving off the threat, or at least the fear, of deflation as QE2 fueled the already rapidly expanding commodity bubble. And it succeeded in stimulating stock prices. Apparently, investors reacted as usual to Fed ease by buying equities even though the usual and crucial intervening step—the creation of money through the lending of bank reserves to finance those purchases—has been missing. The same response no doubt hyped the commodity bubble, which also has been fed by expectations of China and other developing lands buying all the industrial and agricultural commodities in existence.
The leaps in stocks and commodities were reversed last spring, however. The 2010 sovereign debt crisis in Europe was re-run with increased intensity and, now, the feeling of hopelessness. U.S. consumer confidence has nosedived in response to Washington’s handling of the federal debt limit and fiscal restraint as well as persistent high unemployment. And the prospects of slower global growth if not recession threatens recent rapid growth in corporate profits (Chart 2).
Furthermore, we doubt seriously that the Fed’s goal with QE2 was to aid just the folks on top while punishing the lower tier with the higher energy and food costs that flowed from the commodity bubble. But that’s what happened. Until very recently, Americans on the top have benefited from the two-year rally in stocks, commodities, foreign currencies and other investments that were slaughtered during the Great Recession. The rest of Americans are more affected by lingering high unemployment and by falling house prices that are likely to drop another 20%.
Pushing On A String
Despite their lack of effectiveness, QE1 and QE2 as well as earlier non-interest rate Fed policy actions were undertaken because conventional monetary policy, cutting the federal funds rate, was not doing the job. And for two distinct reasons.
First, as usual, the Fed was pushing on the proverbial string. Pulling the string, raising rates, works because borrowers are priced out of the market by rising interest costs. But lowering rates, pushing on the string, may not be effective if creditworthy borrowers, as at present, don’t want to borrow and banks, due to fear and regulations, don’t want to lend. Second, the depth and breadth of the financial crisis, the collapse in housing, the ongoing sovereign debt crisis in Europe, Japan’s continuing two-decade-old deflationary depression, the impending hard landing in China, etc. make the monetary policy string much more limp than usual.
Many forecasters expected Chairman Bernanke to announce some sort of QE3 at August’s Jackson Hole conference, but were unclear what it would entail or how it would help. Would adding another $500 billion in excess reserves to the current $1.6 trillion do any more to induce lending and borrowing? In any event, at that conference, Bernanke proposed no new measures but said that the Fed still has “a range of tools that could be used.”
The Fed Chairman seems to be admitting that the Fed is out of bailout buckets with federal funds now at zero and quantitative easing anything but a raging success. It’s also true that except for bailouts of specific banks, monetary policy is very unspecific. Cutting interest rates may or may not encourage borrowing and investing, but it’s up to the lenders and creditworthy borrowers to decide where any loans get spent. QE2 temporarily helped the upper tier holders of stocks and commodities, but hurt the lower tier at which it probably was aimed by pushing up grocery and gasoline prices, as noted earlier. In contrast, fiscal policy measures can be quite precise. Helping the unemployed by extending jobless benefits does put money in their specific pockets.
We’ll turn to the effects of zero interest rates outside the Fed shortly, but first note that it creates problems for the central bank itself, often with unknown
consequences. Reaching the zero federal funds rate forced the central bank into the quantitative easing business with unexpected and, on balance, poor results and meager effects. This and earlier non-interest rate actions also pushed the Fed uncomfortably close to fiscal policy, which put it in unknown territory and threatened its independence.
This zero federal funds target also led to the strange negative return on 1- month Treasury bills on August 4 during the stampede for liquidity. Investors were paying the Treasury to lend it their money (Chart 3)! Furthermore, a zero federal funds rate leaves the Fed no room to cut it when the next recession looms and the central bank want to provide some offset.
Some observers believe that the recent first time ever negative return on the 10-year Treasury Inflation-Protected Securities (TIPS) is so strange that it belongs in Ripley’s Believe It Or Not! Those folks neglect to mention that TIPS returns are adjusted for inflation. So if inflation over 10 years turns out to be 2% annually, a zero yielding 10-year TIPS will return 2% per year for that decade. Indeed, the spread in returns between TIPS and comparable maturity Treasurys measures market expectations for inflation. The current 2% difference for 10-year securities suggests that investors expect a 2% inflation rate because they are indifferent between the TIPS at 0% and the 10-year Treasury note at 2%.
Many observers believe that low, zero short-term rates have forced investors into longer-term Treasurys, which has pushed yields down and prices up (Chart 4), creating a bond bubble which is sure to break. Well, maybe, but we’ve been hearing similar “bond bubble” arguments since 1981 when 30-year Treasurys yielded 15.25% and we declared that “We’re entering the bond rally of a lifetime.” The rest, as they say, is history.
We persist in our conviction that 10-year Treasury coupon yields, which briefly fell below 2% in August, will continue to drop (Chart 5). We also continue to forecast a further drop in 30-year yields, now 3.6%, to 3% and perhaps even to the 2.6% reached at the end of 2008 amidst the Lehman collapse scare. One well-known bond manager sold off all his Treasurys early this year and then sold them short. He said that owners of government bonds were like frogs slowly being boiled alive and oblivious to the risks of owning Treasurys. As they say, the rest is history.
U.S. banks are paying almost nothing for deposits, which continue to rise in a mad stampede for safety and liquidity. 2.5% Since December 2007, domestic deposits have leaped $1.1 trillion to $8.1 trillion. Indeed, Bank of New York Mellon last month began charging a fee for corporate cash deposits of over $50 billion, and others may be contemplating similar moves. The reason is that even cheap deposits—which on average pay 0.79%, with checking accounts close to zero—aren’t profitable to banks unless they can be lent at margins big enough to cover costs.
And that’s increasingly difficult as the yield curve flattens. One-month Treasury rates were essentially zero two years ago, as they are now, but in the meanwhile, rates for the longer term, in which banks normally lend or buy Treasurys, have fallen considerably. Of course, things aren’t as severe for bank spread lending as in early 2007 when the yield curve was inverted with short rates actually above long rates. The Fed had raised its federal funds target in the 2004-2006 era before it began slashing it in reaction to the financial crisis.
The squeeze on bank interest rate margins couldn’t come at a worse time for banks. With the sluggish economy, total loan demand has been subdued. That weakness is across the board, including commercial and industrial loans to business and consumer credit card borrowing. And with another recession in prospect, loan demand is destined to fall considerably.
Bank yields on assets are in a distinctly downward trend, which will no doubt persist as the Fed continues to keep short rates at zero for two more years and as the likely recession unfolds. No wonder that all of the six largest U.S. bank stocks recently traded at less than their net worth.
U.S. banks also have considerable exposure to the sovereign dent troubles in Europe. Of their global total exposure, 26% is in the Eurozone and it’s 45% if the U.K. is included. European banks are in worse danger due to their heavy ownership of the sovereign debt of troubled Eurozone countries. And their stocks were dumped by shareholders last month. Of course, the Standard & Poor’s downgrade of U.S. Treasurys didn’t help American and foreign banks that hold huge quantities of U.S. government securities.
The essentially zero federal funds rate measures the Fed’s reaction to persistent economic weakness and financial woes here and abroad. These same realities resulted in the seemingly diametric reaction in Treasury bonds when S&P cut its rating on government obligations after trading ended on August 5. This long-anticipated announcement was expected by many (but not us) to result in a collapse in bond prices as Americans and foreigners abandoned tarnished Treasurys. After all, S&P was reacting to the nonstop leap in federal deficits and debt and Washington’s weak response during the debt limit debate charades.
Instead, when trading opened on Monday, August 8, Treasurys continued the leap that commenced at the beginning of the month. And that day, 1-month and 3-month Treasury bills yielded a mere 0.02%. Why? The downgrades enhanced the global rush for safety and liquidity that had started in late July in reaction to the European sovereign debt crisis and slowing global economic growth with necesary overtones. On August 8, the Dow Jones Industrial Average fell 5.5%, the biggest drop since December 2008. Amazingly, all 30 Dow stocks fell and all 500 stocks in the S&P 500 Index suffered losses. Furthermore, corporate bonds and commodities were dumped. Falling confidence in Europe turned joy over ECB plans to support Spanish and Italian bonds to dismay over a possible downgrade of France’s triple-A credit rating.
Follow-on downgrades of government-controlled Fannie Mae and Freddie Mac as well as five triple-A insurers that tend to have sizable Treasury holdings also enhanced the stampede to Treasurys and other safe havens. The $2.9 billion loss for Fannie on home mortgages in the second quarter and posted August 5, up from $1.2 billion a year earlier, and its request for $2.8 billion more in government bailout money didn’t help either. Also downgraded were 73 bond funds, ETFs and hedge funds with 50% or more direct and indirect exposures to Treasurys and government agency securities. We continue to have big 30-year Treasury bond holdings in portfolios we manage, but fortunately aren’t rated so we couldn’t be downgraded. Ten of the 12 Federal Home Loan Banks also had their credit ratings cut by S&P as were the ratings on 11,000 municipal issuers—to keep them in line with the lower Treasury rating.
Without doubt, there is a huge global crisis of confidence at present. It essentially results from the realization that governments, through their monetary and fiscal policies, have no magic bullets they can fire to return the economy to the 1980s-1990s salad days of rapid growth and soaring stocks. This is The Age of Deleveraging, and all the government efforts to date pale in relation to the deleveraging in the private sector.
Since early 2006, U.S. federal plus state and local debt has jumped from around 3% of GDP to 9.6% in the first quarter, or about a seven percentage point rise. But during the same time, the private sector delivered from about 16% borrowing-to-GDP to -0.5%, a 16 percentage point drop. So all the government deficits that lay behind that borrowing and the fiscal stimulus they represent offset less than half the deleveraging of the private sector.
A key reason why monetary and fiscal policymakers are out of ammo is because of the questionable effects of earlier efforts. Quantitative easing by the Fed piled up $1.6 trillion in excess bank reserves that lie idle while pushing up grocery and gasoline prices for lower-tier consumers, the very people the Fed aimed to help. Fiscal stimuli added over $1 trillion to federal deficits and debt, spawning such a public and political outcry that further massive programs are off Washington’s table.
In Europe, it’s becoming clear that the Eurozone either breaks up or moves toward more unity and more bailouts. We’ve believed since the euro was established in 1999 that the basic flaw was combining the Teutonic North with the Club Med South under a common currency with no central fiscal control or prospect of it in such diverse lands. The current hope is to create a Eurobond to finance sovereign debts for which the Eurozone as a whole will be responsible.
But that would require central control over national tax and spending policies, a difficult change to sell to profligate countries like Greece and Portugal. It also means that the strong countries, led by reluctant Germany, would continually subsidize the Club Med set. At present, the Eurozone fiscal deficit as a whole is about 4.4% of GDP, not that bad since it’s held down by the Teutonic North’s fiscal discipline, and debt-to-GDP is around 87%, far from the number for Greece and Ireland.
So the Eurozone as a whole would be a strong borrower. But how much more debt could be piled on the underlying backs of Germany, the Netherlands, Finland and other strong economies before Eurobonds become junk? Furthermore, eurozone economies are slipping toward recession, as evidenced by the nosedives in consumer and business confidence.
The reality is that governments, which escalated their monetary and fiscal leverage to bail out financial markets and other private sectors, are now being forced to join those private economic units in deleveraging. Attempts to hold back the tide, such as the limits on selling stocks short in France, Italy, Spain and Belgium, are ineffective attempts to blame market weakness on rumor-mongers and unscrupulous traders.
This is not to say that all the earlier monetary and fiscal stimuli here and abroad was in vain, even though it didn’t offset the massive private sector deleveraging and return economies and finance markets to robust health. The basic data shows that from the beginning of the recession in December 2007 through July 2011, disposable (after-tax) personal income rose $960 billion, $705 billion from increases in government transfers and tax reductions. From the $960 billion, 31% was saved, much more than the current average saving rate of 5%, but 78% was spent.
Dash To Cash
With the global crisis of confidence has come a universal lust for liquidity, especially cash. In the week ending August 1, the M2 money supply, which includes currency in circulation, bank deposits and retail money market funds, leaped $159 billion, or 1.7%, the third biggest jump since 1980. In perspective, the biggest was 3.2% right after 9/11 and the second, the 2.3% gain in the week of September 2, 2008 when Lehman collapsed (Chart 6).
In Europe, bank deposits at the ECB hit a 2011 high of €145 billion in early August even though that central bank pays a lower interest rate than interbank markets. And many banks probably will need the money later. The July “stress tests” were widely viewed as too easy to pass, as reinforced by an unusual move recently by the International Accounting Standards Board. It said that some European banks are using their own models to value Greek debt rather than the required market prices to determine the securities’ fair value. The “mark to model” rather than “mark to market” approach vastly overvalues the troubled Greek government debt they hold that has collapsed in value. Yields on 2-year Greek government debt hit a record of 43% in late August. Similarly, drops in the value of Spanish and Italian government bonds have impaired the balance sheets of their banks which hold large quantities of those sovereigns.
In July, the Committee on the Global Economic System, a central bank oversight group, said that an increase in “sovereign risk adversely affects banks’ funding costs through several channels, due to the pervasive role of government debt in the financial system.” The declining value of government debt, the panel went on, could weaken bank balance sheets and make bank funding more difficult. Indeed, European banks have been scrounging for U.S. dollars to add to their already-large liquidity hordes as U.S. money markets and other traditional sources became reluctant to lend to them.
Stressed Greek Banks
Meanwhile, Greek banks are stressed by massive withdrawal of deposits that move to safe-deposit boxes and under mattresses. One unlucky saver stashed cash in a brick wall but rats ate it. Deposits in Greek banks by households and businesses peaked at €238 billion in September 2009, but plummeted to €188 billion this June. About half of these withdrawals have fled the country, the central bank estimates, as chronic tax evaders fear a crackdown.
The Greek bank withdrawals have led to a bank liquidity shortage and increased reliance in the ECB for funding, and also to bank lending cuts and a further deepening in the Greek recession. The government now estimates a 5% drop in GDP this year compared to the 3.8% decline forecast on July 1.
Furthermore, Greek banks have heavy exposure to Greek government bonds, now rated junk, so they’re frozen out of the interbank lending market. Piraeus Bank recently announced a €1 billion writedown of its bond holdings. It’s also borrowing from a special central bank fund used to cover cash needs, the second Greek bank to do so, since its collateral is too weak to back ECB loans. The Piraeus writedown was part of the second Greek bailout deal reached in July.
The ongoing banking crisis no doubt was key to the recent decision of EFG Eurobank Ergasias and Alpha Bank, Greece’s second and third largest banks, respectively, to merge into the nation’s largest. This strikes us as two drunks leaning on each other in an attempt to keep each other standing.
Another result of the zero interest rate world was the earlier investor rush to junk securities in their zeal for higher yields. That drove the spread between junk bonds and Treasurys from its 20 percentage point peak in December 2008 almost back to the previous low in June 2007, according to our friend, Prof. Ed Altman of NYU. In 2009, junk bonds’ appreciation and interest returns combined were 57.3% and a further 15.3% in 2010. As in earlier boom times, investor zeal made refinancing sub-investment-grade securities easy, so defaults in the first half of 2011, at 0.2%, were also near record lows. Refinancing money was so readily available that defaulting on junk securities took real skill.
But the August agonizing reappraisal of financial markets has hit junk hard. Retail investors, who poured $2.8 billion into junk mutual funds in July and $43.8 billion between March 2009 and February 2011, yanked out $4.6 billion in the first three weeks of August. That forced junk mutual funds to sell securities, resulting in a -5.1% total return in the same weeks.
The junk yield spread over Treasurys, using Barclays Capital High Yield Index, leaped to 7.66 percentage points last month— the highest since November 2009—from 5.87 points at the end of July. This spread level, in the past, is associated with recessions when slow growth and lack of junk security financing hypes default rates.
With this rapid reversal, it’s not surprising that the junk issuers raised only $1.2 billion in August, down 93% from July’s $18.2 billion and the lowest since the market dried up in December 2008.
REITs also benefited from investor zeal for yield in a low interest rate world. Also, investors earlier saw them as immune from Europe’s debt crisis and benefiting from the expected revival in economic growth and employment and the resulting demand pick-up for commercial real estate. In the first half of 2011, the Dow Jones Equity All REIT Index was up 9.9% vs. 6% for the S&P 500. In the last two years, REITS returned about 30% annually.
As Insight readers know, however, we’ve been cautious on REITs except for those involved with rental apartments and medical office buildings, and felt their stocks got way too far ahead of themselves. Recently, they’ve fallen back along with stocks in general. Also, lending for commercial real estate-backed securities is drying up, curtailing REIT acquisitions and debt refinancing. And the looming recession will cut demand for office space, hotel rooms and warehouses.
Are Stocks Cheap?
Low and zero interest rates also influence investors’ views of the values of stocks. The theory says that lower interest reduces the discounting rate that converts future earnings into current stock values and thereby raises their present worth. Also, lower interest rates are supposed to raise price-earnings ratios by making stocks cheaper relative to bonds.
In any event, stock bulls and many equity analysts believe that corporate profits growth has been so robust that even considerable economic weakness will not depress stock prices significantly from current levels. And, as usual, equity analysts see robust company-by-company earnings for 2012, with a gain of 14.4% for this year’s estimate for S&P 500 operating earnings. More sober, top-down strategists still look for a rise of 5.9%. Those numbers put the S&P 500 currently selling at 10.3 and 11.4 times next year’s earnings, respectively—reasonably cheap relative to the 19.0 average P/E since 1960.
But only two quarters of 2011 earnings are recorded so far, and estimates for the second half may prove to be far too rosy, jeopardizing the bottom-up analysts’ forecast of a 17.8% gain for 2011 and 14.8% for the top-down strategists. Similarly, their forecasts for 2012 may prove unrealistically optimistic.
We’ve never understood the concept of P/Es that compare current prices with next year’s earnings forecast. It strikes us somehow as double- discounting, of forecasting future earnings and then treating those forecasts as certain enough to determine the current values of stocks. This approach works in long bull markets with steady earnings gains, but come a cropper when the bear visits.
Our friend, Yale Professor Robert Shiller, avoids this problem as well as the volatility of recent corporate earnings by calculating the S&P 500 P/E based on earnings over the last 10 years (Chart 7). His average since 1960 is 19.4, implying that stocks in July when his P/E was 22.9 were 18% overvalued. More important, in reaching that long-term average P/ E of 19.4, stocks spend about half the time above it and half below. Most of the last decade has been above the average line, so there may be some catching up on the down side. This fits our view of a decade or so of deleveraging and a secular bear market that started in 2000.
The U.S. and Japan
Interest rates close to zero and all the related issues are relatively new in the U.S. and Europe, but they’ve been around in Japan for two decades. So, many wonder if the U.S. is headed for Japan’s 20-years-and-running deflationary depression. And regardless, what does the Japanese experience tell us about living in this atmosphere?
There are a number of similarities that suggest that America is entering a comparable long period of economic malaise. The Age of Deleveraging forecasts a similar decade, at least quite a few years, of slow growth and deflation as financial leverage and other excesses of past decades are worked off. The recent downgrade of Treasurys by S&P parallels the first cut in Japanese government bond ratings in 1998, followed by S&P’s cut to AA-minus early this year and Moody’s reduction from Aa2 to Aa3 last month.
The recent slow growth in the U.S. economy—real GDP gains of 0.4% in the first quarter and 1.0% in the second—looks absolutely Japanese. Furthermore, the prospects of substantial fiscal restraint in the U.S. to curb the federal deficit is reminiscent of tightening actions in Japan in the mid-1990s. The economy was growing modestly, but deficit- and debt-wary policymakers in 1997 cut government spending and raised the national sales tax to 5%. Instant recession was the result.
Big government deficits in recent years are another similarly between these two countries and the U.S. net federal debt-to- GDP ratio is headed for the Japanese level. Japan’s gross government debt last year was 226% of GDP, far and away the largest ration of any G-7 country. All governments lend back and forth among official entities so their gross debt is bigger than the net debt held by non-government investors, and Japan does more of this than other developed lands. Still, on a net basis, her government debt-to-GDP is only rivaled by Italy’s and leaped from a mere 11.7% in 1991 to 120.7% in 2010. Is the U.S far behind (Chart 8)?
Japan, in reaction to chronic economic weakness, has spent gobs of money in recent years, much of it politically-motivated but economically questionable, like paving river beds in rural areas and building bridges to nowhere. Is that distinctly different than the U.S. 2009 $814 billion stimulus package that was supposed to finance shovel-ready infrastructure projects when, in reality, the shovels had not even been made yet?
A key reason for the 2009 and 2010 U.S. fiscal stimuli and continuing deficit spending in Japan is because aggressive conventional monetary ease did not revive either economy. Zero interest doesn’t help when banks don’t want to lend and creditworthy borrowers don’t want to borrow . Both central banks found themselves in classic liquidity traps, so both resorted to quantitative ease, without notable success.
But Differences, Too
There are, then, many similarities between financial and economic conditions in the U.S. and Japan. Nevertheless, there are considerable differences that make her experience in the last two decades questionable as a model for America in future years.
The Japanese are stoic by nature, always looking for the worst outcome while Americans are optimistic—not as optimistic as Brazilians, but still prone to look on the bright side. Otherwise, why would the Japanese voters stand for two decades of almost no economic growth? Japanese are comfortable with group decision-making while Americans revere individual initiative, something the Japanese disdain. The nail that sticks up will be pounded down, is a favorite expression there. Perhaps because of this, the government bureaucracy in Japan is much stronger than in the U.S. while elected officials have less control and room for initiative.
Despite little economic growth, Japanese enjoy high living standards. And the Japanese are an extremely homogenous and racially-pure population.In a related vein, immigration visas don’t exist in Japan, so there’s nothing in Japan like the chronic shift of U.S. income to the top quintile. Nothing like the two-tier economic recovery that benefited top-tier stockholders in 2009-2010, but left the rest struggling with collapsing prices for their homes and high unemployment.
Japan in the post-World War II era has been an export-led economy. “Export or die,” is the watchword. The result of robust exports and weak imports linked to anemic domestic spending is her perennial current account surpluses, which, along with earlier high saving by households and now by businesses, allow her to finance her huge government deficits internally, with foreigners owning only 5%. As a result, her government bond yields are extremely low.
In contrast, the U.S. is a chronic importer with a chronic current account deficit. So foreigners have perennially bought Treasurys with the resulting dollars they earn, and they now own about 50% of them. And Treasury note and bond yields are much more controlled by global forces and higher as well than in Japan.. The U.S. is largely an open economy but Japan’s, except for her formidable export sector, is largely closed to the outside world.
Another big difference is the chronic strength in the yen and long-time weakness in the dollar, resulting in part from the difference between Japan’s chronic current account surplus and America’s chronic deficit. Even near-zero short-term rates and 10-year government bond yield of about 1% do not deter those who lust for the yen. Of course, in a zero interest rate world where interest returns have dropped close to traditionally low Japanese levels in the U.S. and elsewhere, Japan at present does not have much of a competitive disadvantage.
The yen’s strength has led to Japanese manufacturers moving much of their production to lower-cost areas, but deflation in Japan has offset some of the difference. Corrected for deflation and on a trade-weighted basis, including trading partners such as Switzerland with robust currencies, the yen has been relatively flat since the 1980s, according to a Bank of Japan analysis.
Nevertheless, the government has intervened in currency markets numerous times, most recently spending $13 billion in early August, to arrest the yen’s climb vs. the greenback. And, of course, a government intervening against its own currency can’t run out of ammunition since it can easily create more of its own currency to sell on the open market. Still, intervention success has been limited, short- lived and expensive. Even a determined government with unlimited ammo has not been able to overcome the gigantic global currency markets that trade trillions of dollars daily.
We conclude that the differences between the U.S. and Japan are too great to use the Japanese economic experience in the last two decades as a template for the U.S. in coming years. Still, as discussed in The Age of Deleveraging, we expect a similar lengthy period of slow growth and deflation as the economy delevers. In any event, can policymakers do much to forestall this outlook? We argue in The Age of Deleveraging and did so earlier in this report that they can’t any more than the Japanese have been able to generate robust economic growth.
As we’ve been discussing, near-zero interest rates have distorted the financial and economic scene by pushing many investors into risky investments in foreign lands, commodities, junk securities and other investments they may come to regret. But many remain in bank CDs and money market funds for safety despite almost nonexistent returns.
Money market 7-day interest returns in August were a trivial 0.03%, and they would have been negative in many cases if fund managers had not waived their fees. And this condition will likely persist. The federal funds rate target, which rules other short-term returns, has been in the 0 to 0.25% range for three years, and the Fed intends to keep it there for two more years, barring a burst of inflation or a big drop in unemployment.
Save More or Less?
Will Americans be discouraged by low returns and save less, or will they save more to reach lifetime goals? They’ll do the latter, in our judgment, which is one more reason why we expect the saving rate to jump back to double digits. Others, which we’ve discussed many times, include distrust of volatile stocks, the shrinking house appreciation that was tapped earlier to fund oversized spending, the postwar babies’ desperate need to save for retirement and chronic high unemployment, which encourages saving for contingencies.
In last month’s Insight article, “Debt Bomb?,” our analysis slowed how important interest rates are to interest paid on the federal debt, the resulting contribution to deficits and to the growth in the debt total. As we noted then, the average maturity on the public U.S. debt outstanding was only 4.75% in 2010, at the low end of the yield curve. Furthermore, long-term Treasurys’ share of the debt outstanding has shrunk in the last decade.
The nonpartisan Congressional Budget Office’s new projections, which incorporate the reductions in federal spending enacted in August but also assume that the Bush tax cuts will expire on schedule, result in deficits totaling $3.5 trillion over the next decade, down from the $7 trillion forecast in January. The CBO assumes that GDP growth basically catches up from the depressed rates of recent years, rising to 5.0% annual growth in 2015 before dropping back to 2.3% in 2020 and 2021.
In contrast, we see slower annual growth, 2.0%, throughout the decade. The unemployment rate is assumed by the CBO to drop back to 5.2%, again very optimistic in our judgment. Faster economic growth propels taxes and thereby restrains the deficit while also reducing the deficit-to-GDP and debt-to-GDP ratios by enlarging their denominators. Lower unemployment also eliminates the deficit-enhancing pressure to create more jobs that concerns us.
The CBO sees 3-month Treasury bill rates rising gradually to 4.0% over the next decade and 10-year Treasury note yields to 5.3%. Its net interest paid projections divided by the CBO’s debt forecasts yield its effective interest rate for financing the debt, and it rises from 2.2% last year to 4.6% in 2021. As a result, net interest-to-GDP peaks at 2.8% in 2020, below the earlier peak of 3.2% reached 20 years ago. Even with the CBO’s assumptions that the effective interest rate on the federal debt jumps from 2.2% to 4.6%, interest costs-to-GDP does not skyrocket. With our projection of no rise in interest rates over the next decade, interest costs-to-GDP reaches only 2.4% in 2021 even if we assume that the debt held by the public rises $1 trillion per year for a decade and nominal GDP rises only 2% annually. Either way, relatively low interest rates in future years will help contain interest paid-to-GDP ratios for the federal government and, therefore, growth in the government deficits and debt.