Equity and credit markets were bludgeoned this month after China’s currency devaluation confirmed what the commodity bust had previously hinted: Global output is in trouble if its main demand engine is stalling.
The problem appears deeper and more widespread than just an output problem. Pervasive capital and resource misallocations over many years have littered financial detritus across economies, and today there is no obvious outlet for more credit on a scale large enough to make a meaningful macroeconomic impact. Market mayhem in August may have been a mere manifestation of unsustainable global economic leverage, a structural issue unlikely to go away easily. Defending this argument first requires a wonky review of money and credit:
• Human desire may be infinite, but economic demand requires means, that is, money or credit.
• Credit is a direct claim on money, not a claim on assets or production. (One may not pay off a bank loan with a sofa bed.)
• The global stock of money and credit is technically unlimited in the current global monetary regime.
• The global value of money and credit is functionally limited over time by the ongoing value of global production and assets.
• The total value of money theoretically equals the value of everything not money. If the two values are not in the same ballpark, then they will eventually be brought closer together through either price deflation or by increasing the money stock.
• Lots of money relative to credit creates no future problems for asset values and production. However, lots of credit without lots of money (for example, leverage) demands that either credit be destroyed or more money be created.
Despite quantitative easing, there is an overabundance of systemic leverage presently, which implies that more money must be earmarked for future debt service and repayment and that global growth can no longer rely on an animal-spirit-driven business cycle. This structural headwind may practically explain economic and market dysfunction in China and beyond.
In the 25 years since the Iron Curtain fell and China opened its stock markets, global production migrated from mature economies to emerging ones with lower manufacturing costs. Cheaper goods and services exported from emerging markets generally displaced higher-cost producers in developed markets. EM economies effectively exported deflation (and imported inflation), whereas the opposite was true for DM economies. Deflationary pressures in DM economies encouraged their central banks to pursue inflationary policies to keep asset prices stable.
Domestic debt loads also expanded in places like China, despite lacking credible currency boards, deep and domestically sponsored capital markets, adequate regulatory controls and trustworthy court systems. Such economies relied on trade and foreign investment, prompting policymakers to use their currencies as blunt tools to promote mercantilist agendas. Credit and debt grew large but lacked stable financial infrastructures.
Meanwhile, economic policymakers in DM economies continued to maintain too-easy monetary conditions to offset deflation imported from EMs. Financial and real assets rose as a result, providing a wealth effect to consumers who could effectively borrow against ever-higher-priced asset collateral to consume goods and services. Tax-deductible interest also encouraged economywide credit creation and debt assumption. Securitization innovations further created the perception that debt need never be extinguished. Goods and services production became derivative to asset gains, which ceased to be the by-product of funding capital formation.
The tipping point came in 2008, when U.S. markets implicitly acknowledged that financial leverage had raised asset prices to levels irreconcilable with sustainable production. Global DM policymakers dropped overnight lending rates to zero, ostensibly to recharge (that is, releverage) their economies. It was too late. The risks inherent in leverage were exposed to the masses. Policymakers, unwilling to let their economies naturally adjust prices to better reflect production, began to create new base money in the form of bank reserves. (Base money creation effectively covers “short money” positions that were created by banks when they originally lent M1 and M2 into existence.) This partially deleveraged bank balance sheets but did not deleverage households, corporations or governments. In fact, according to a study by McKinsey & Co., the global stock of debt outstanding has increased by $57 trillion since the financial crisis.
A reconciliation of prices and production value seems inevitable, given excessive global leverage, excess global output capacity and the resulting decline in capital-driven credit demand. Money creation that bolsters only asset prices has proved to be an ineffective economic stimulant. This presents a very inconvenient truth: The natural path of prices for global goods, services and wages is down, whereas the need to service unproductive debt continues to rise.
To monitor the situation, economists and policymakers have kept an eye on debt-to-gross-domestic-product ratios. This is like keeping an eye on a shark as it eats your surfboard. Relying on this metric as a warning sign has three obvious problems: 1) GDP only tells us what happened last quarter and has no bearing on incentives driving future output growth. 2) Output is a measure of economic flow, whereas debt has become a permanent stock item that needs to be serviced (and, dare we say, repaid). 3) GDP calculations include financial output, and finance creates more debt than the goods and services production it engenders. So, debt-to-GDP ratios do not tell us how much or how quickly economies are hollowing out production relative to debt service.
Finance is critical to economies when there is a surplus of productive capacity in relation to available savings, and perhaps even more critical (cynically speaking) when it is politically advantageous to sustain the appearance of normalcy. But finance is not commerce. Today there is global overcapacity and negative net real savings (adjusted for debt), and, without a new outlet for credit that captures the world’s imagination, we should expect the frequency of asset de-leveraging and currency devaluations to rise.
Ironically, this frightening macroeconomic state of affairs does not necessarily imply falling secular asset prices. Strong central banks, like the Federal Reserve, have unlimited balance sheets and an implied mandate to keep bank collateral (nominal asset prices) stable.
Paul Brodsky is the founder of Macro Allocation, a Tampa, Florida–based macroeconomic and market research and analysis firm for advisers, investors and fiduciaries.
