We are major students of economic history, and often find the best way to describe the current situation is to put it in the perspective of the past. Having said that, no two periods of history are precisely the same, so it is important to focus on the forest not the trees. Perhaps most importantly, it is critical to note that history has a way of morphing from what actually happened to an accepted consensus memory of what happened. Even the most famous quote about history – that it may not repeat, but certainly rhymes – is inaccurately attributed to Twain to give it more weight. With these warnings, we make the following observations on where the world economy appears to be from a historical perspective.
First and foremost, is that we are in a period of leadership transition similar to when the US took over as global economic leader from the UK during the early 1900s. In the future, it will be Chinese economic policy and success that drives the global economic cycle, not the G7. In 2013, a strong improvement in China’s roughly $8 trillion economy from roughly 5% real GDP growth in 2012 to near 10% in 2013 will drive a rebound in their major suppliers in the emerging markets. Growth emanating from this sphere of influence will provide several times the global economic impetus of whatever happens in the $40 trillion economy of Europe, the US or Japan. We expect Japan’s $5 trillion economy to be resurgent after a near 25% devaluation of its currency. However, this should come largely at the expense of their major trade competitor, Northern Europe. We do believe Europe ($18 trillion) will exit recession and enter a period of weak growth, due mostly to improved exports to the Emerging Markets. The US, as noted last week, is expected to improve slightly as the drag from the public sector abates – but as the strongest of the developed world economies already, it will see the smallest improvement in growth.
In our view, China is exiting its Robber Barons phase of expansion and entering a period with more government regulation and a greater sharing of the wealth, especially by breaking up government monopolies. The UK and the US both went through this transition, in the late 1800s in the UK and early 1900s in the US. In both cases, regulation was accompanied by greater power for the masses via unions and increased voting power. We see China sharing the wealth via income redistribution and breaking up monopolies, but the Party will be far slower to allow competing power bases from unions or democracy – so the consequences for economic expansion should be more limited.
The most meaningful change underway in China is the transition from a government controlled bank based lending to much greater use of private market sector lending via wealth management products (WMPs). Interest rates on bank loans – primarily to state owned enterprises — have traditionally been well below nominal GDP growth. This both encouraged rapid growth in credit demand and limited the downside effects, as even during recessions nominal growth exceeded interest charges so bad debts were managed. Rates earned on WMPs are far higher – a replacement for the informal lending markets that have always existed. However, in today’s credit constrained Chinese market the borrowers are often those who traditionally borrowed from banks – especially provincial governments directly or indirectly. For 2013 (and likely 2014) the surge in new lending that is underway will buoy the economy. However, the world’s new cyclical leader appears to be paving their way to their first globally significant correction somewhere on the economic horizon.
Back to the Future
Like the first of the Michael Fox trilogy, the US economy may be best compared to the late 1950s (and early 1960s) – a period of low interest rates and inflation with modest growth. Financial markets were for professionals, with the rank and file still scarred by the memories of the 1930s. Market concentration was the source of expansion with monopoly profits providing the steady income for new investment. Banks were staid and riskless, still operating under the 3-6-3- rule (borrow at 3 lend at 6 and go home at 3) to only those who did not need money. Commercial lending dominated, as mortgages were largely the purview of the GI bill and the government pools. Taxes were steadily rising, as the federal government worked to pay down debts from WWII and Korea and state and local governments funded investment in education. Yes, we know there are lots of differences as well, but a very conservative post-crisis government dominated business world seems likely to persist in the US for several years.
One key aspect of the 1950s was that people paid down debt. We have been asked a lot of questions about deleveraging lately and the consequences that it will have for the current cycle. For us, the key remains that the deleveraging of the household sector is being financed by the increased leverage in the government sector. Only with the end of the payroll tax holiday have we seen any movement toward paying down the “consumption deficit” which combines household and government shortfalls. The offset to household and government funded overspending is business savings – both by domestic and foreign. For the “consumption deficit” to go down, either domestic businesses have to invest part of their fortress balance sheets or the trade deficit has to come in as domestic businesses gain on foreign producers. An energy based narrowing of the trade gap is in the offing, but a more likely near term benefit is simply from improving growth overseas in the China led emerging markets, resurgent Japan, and recovering Europe all lifting exports while import meander on lackluster US growth. However, as Friday’s trade numbers show, strong Chinese exports generally are the result of heavier import demand from the developing world.
Adopting Best Practices
In periods of extreme uncertainty, like after the Great Depression, policy makers differ on the right solution with some favoring the tried and true while others experiment with new strategies. Over time, policy converges as those who are doing the worst alter their policy to adopt the most successful – or least unsuccessful – methodology. In the Great Depression, the UK was first to drop the gold standard in 1931 – having been the first to go back on in 1925 at far too strong an exchange rate. Most others dropped off in 1932, but the US waited until 1933 and France until 1936. Their delay was because they had most of the world’s gold, and so the greatest ability to maintain the status quo. The result of their delay was a deeper recession in the US and France than elsewhere. Italy had followed a state corporatist model under Mussolini’s fascist government and suffered less during the early phase of the Great Depression. Imitators sprung up in Germany, Spain, Hungary and elsewhere. After the Great Inflation of the 1970s, Thatcherism became the dominant economic model replicated as Reaganomics in the US, Rogernomics in New Zealand and Economic Rationalism in Australia.
As the world tries to adjust in the post-Lehman world, many countries have tried different combinations of fiscal stimulus, conventional and unconventional monetary policy, and currency regimes. The US was first to employ quantitative easing to finance the bank bailout expanding its balance sheet by over $1 trillion by the stock market bottom in March 2009. The UK began an aggressive quantitative easing in March 2009 ($300 billion) after engineering a 25% decline in their exchange rate against major competitors. The QE was in part to offset much more austere fiscal policy than in the US. Europe watched the English speaking nations until 2010 following the March Greek crisis, but only introduced Long Term Repurchase Operations (LTRO) in December 2011. Demands for extreme austerity from peripheral borrowers have resulted in sharply different economic performance across the Eurozone, but ultimately all nations have been dragged into recession. Most recently, Japan has joined in on currency manipulation and quantitative easing – jawboning down its currency by 22% in a few weeks since the election of Prime Minister Abe and promising far more money printing by the central bank. Though Britain is holding to its tough love approach on fiscal policy, only the Eurozone countries forced into austerity have chosen this path. The US avoidance of the fiscal cliff suggests that deficits will remain quite large by choice, where UK deficits are an unwanted byproduct. Germany used fiscal deficits to maintain employment via work spreading, helping it suffer the least damage early in this recessionary period. Bottom line, it appears the consensus in the developed world is shifting toward money printing as the key policy against recession. Fiscal austerity, not so much. We do not expect the upcoming debt ceiling/sequester debate to alter that trend.