I recently had a conversation with a friend who was cautiously optimistic about the US economy and its growth potential going forward. He cited statistics about corporate profits and a housing recovery and how the US was better off economically than many other countries and regions. He thought we were posed for another growth spurt that would be reflected in higher stock prices.
I agreed with his basic statistical evidence, which offered a snapshot of the distorted present rather than a sound projection into the future, leading me to a bit of a different interpretation regarding the investment risks going forward. I tried to convey my analysis by verbally explaining what lay between here and there. I think it’s easier to explain using the following illustration:
The US (and world economy) fell partly off a cliff in 2008 and 2009. One problem is that the previous peak was built on the hot air of cheap credit rather than the firm bedrock of economic productivity. Now, the US economy is still stuck at point A on the chart. The policy experts at the Fed and in Washington are desperately trying to prevent us from falling to point C by bridging the chasm between A and B with cheap liquidity, unproductive spending stimulus, and false confidence that pigs can fly.
My friend is looking backward and forward to see how the US economy has rebounded in the past and will eventually return to point B with an upward growth path. My explanation went something like this: In order to get back to gradual, step-wise positive growth (climbing the mountain one step at a time), we first need to adopt prudent mountain climbing skills. In economic terms, this means working, saving and prudently investing in productive activities. To do this we need functioning capital, labor, and product markets guided by accurate prices. Instead, in their attempts to prevent us from falling into the bottomless ravine at point C, our policymakers are inhibiting citizens from pursuing productive activities. In other words, we can’t fly from point A to B, we have to get back to climbing fundamentals, but under the continued price distortions promoted by the wrong monetary, tax, and spending policies, many people are rationally returning to the speculative behavior that caused the crisis in the first place. Most of our private debts are being transferred to the public sector, which not only means the debts grow (see previous post on debt-driven spending over the past 30 years) but that nobody really has much incentive to watch the cash register: government borrowing and spending just keeps growing without any consideration on whether this is helping real growth and wealth creation.
We have some real world references to point to here. In the 1990s Japan had a real estate and stock market bubble that burst just like we experienced in 2008/09. They adopted the same strategy of excess liquidity and banking bailouts that prevented losses from being reset and resources from flowing back into productive activities. The Japanese have sat at point A and watched point B recede for the past 25+ years.
Another case, just the opposite, is tiny Iceland. Ten years ago Iceland embarked on a fantastic bank-leveraged financial bubble that popped with a bang in 2008. Because they could not borrow and spend their way out of bankruptcy, in a matter of weeks Icelanders went to bed at point A and woke up at point C. The phony wealth creation evaporated with an instant price reset as the Icelandic krona lost more than half its value. But Iceland is now back on a positive growth path climbing back up the mountain of growth founded on hard work and sound financial policy.
As you might have guessed, we are pursuing the same policies as Japan, not Iceland, because we can and the necessary price reset is politically unacceptable. How many of us would willingly see all prices revert to say, 2001? But we really can’t get from point A to B on the backs of flying pigs. In trying to do so we risk two possible outcomes: one, we create another bubble and a bigger crash which will be unmanageable because the policymakers will have run out of bailout money; or we sit and watch point B recede ever into the future as economic opportunity declines, growth stagnates, and we all grow older.