So the Dow hit a record high. Good for it. Congratulations to Ben Bernanke. Does it mean we’re out of the woods finally? Does it mean a breakout year for US growth? Sadly, neither. What we are experiencing in the Dow, and increasingly here as well, is the fruits of financial repression.
“Financial repression” is a phrase used to describe a set of policies that reduce the real interest rate to zero or below. These are enacted by governments or regulators aiming to mitigate a debt burden in either the public or the private sector.
The low interest rate has the combined effect of lowering debt issuance and servicing costs, as well as increasing bank margins. The knock-on effect of currency debasement boosts competitiveness, investment and inflation. All of these assist in rendering the debt-stock in question more manageable and, ultimately, shrinking it in real terms.
These conditions already exist in most advanced economies as private sectors in the United States, Europe and Japan are at various stages of unwinding debt bubbles of the past few decades. The technicals vary but the tools are the same.
Japan remains a contained mercantilist state, fighting its demographic headwinds and formerly corporate debt bubble via endless deficit spending of its government, which borrows from its people at extraordinarily low rates guaranteed by repeated quantitative easing measures conducted through its central bank.
The US is a more open economy and is making more swift progress than Japan did in its deleveraging, but its household and corporate debt loads are still miles above historical norms. Its government also continues to deficit spend at rates in excess of sustainability, assisted in its endeavour by fabulously low interest rates across the curve, in part held in place by quantitative easing by its central bank.
Like Japan, this has stabilised its financial system and some renewed borrowing is apparent as household formation picks up. This will continue but with each successive year get more difficult. Growth from a low base has proved hard. Growth from each higher base will be tougher still.
Owing to more favourable demographics and a more dynamic economy in general, US financial repression is unlikely to last as long as that of Japan. But if it takes half the time, the period from the GFC until now is about one-third of what will be required. Meanwhile, the US will export its weakness wherever it can.
Europe is harder largely because it barely exists beyond its putative bureaucratic dream. The disparate group of states with a shared interest rate and currency, but little else, uses a combination of super-low interest rates, fiscal engineering and constraint, as well as wage deflation to resolve its various debt bubbles.
It’s approach has merit in the textbook and in the capitalist ledger, but its refusal to support the process with shared debt burdens constantly threatens political mayhem. Europe may win in the end but only if it can prevent civil war.
And it does not stop there. The same conditions of financial repression permeate much of the emerging market world as well. The matrix is different but the tools are the same. In China, interest rates are also held at low levels relative to growth and inflation to boost bank margins in the face of mounting bad loans derived from years of overspending on uneconomic infrastructure to meet official growth targets.
The underlying dynamism of the economy is real and its prospects for large productivity gains very high in the long term. But the rise to influence of companies and individuals that have a vested interest in sustaining the unsustainable means financial repression goes on.
Capital controls ensure the currency is fixed and that domestic liquidity is ubiquitous. The unwind will be long and each subsequent year will face the same question as the last, more pressing each time: By how much will the communists renew spending on bridges to nowhere?
Which brings us to Australia. So far, it has been different Down Under. Despite a huge household debt load, Australians have not faced a deleveraging cycle. We have to date disleveraged, reducing our borrowing growth rates, not reversing them. This is has been made possible by a once-in-a-century mining boom that boosted incomes, jobs and the simple velocity of money in the economy, easing the generational shift away from debt accumulation which is part and parcel with financial repressions.
We’ve staved it off with government spending and guarantees to our banks, as well as a serendipitous mining boom. But the underlying fact will remain. Australian households have too much debt. The level must fall relative to the surrounding economy. Financial repression is the way it will do so. That is a structural shift, not cyclical.
And it explains why the Australian sharemarket is also booming. Though valuations are already remarkably stretched, financial repression boosts financial assets as official interest rates fall and risk premiums contract.
You will no doubt see various pundits predicting spectacular earnings growth to rationalise the higher prices, but there is little chance of delivery. The ASX 200 is priced at the highest mid-cycle forward price earnings ratio in recent memory (around 20 times) and consensus estimates for earnings growth are an aggregate 25 per cent over the next two years.
As China slows and the terms of trade continue to correct, mining investment falls and Australia’s new normal credit constraints remain, this is delusional. That’s not to say that stocks will fall. Certainly financial repression is working over time in the US. And it is difficult to find any macroeconomic reason for it to stop now. The one serious threat to the US rally is rising long bond rates, which would snuff out US housing.
But as long as Europe and China continue to struggle, safe-haven flows should contain any selloff in bonds. Inflation is no threat. The world exists in a state of grotesque overcapacity. Its underlying condition is deflationary. And the rebalancing away from China will only depress periodic bouts of commodity inflation. As for official intervention, phht, the uber-doves of the Fed are unlikely to upset things for years yet.
But you should understand why stocks are where they are, because it affects your investment strategy. “Value” arguments that support “buy and hold” approaches to stocks make no sense in financial repressions (that’s the whole point). On the most fundamental level, the rally is an artifice and should be treated a such.
David Llewellyn-Smith is the editor of MacroBusiness. The site offers free 2013 forecasts for the Australian economy, the Australian dollar, Australian property and the top ten stock picks for the year.
The original release of this article first appeared on the website of Hangzhou Night Net.