I’m inclined to lean bearish. Maybe that’s just because being bearish over the last few years has been the right thing to be, but I can’t help but feel like we’re in this for the long haul. If this recession really is a deleveraging, then it’s going to be a while before things get going again economically. Here are a couple of my concerns:
- Public Debt: We will eventually run out of money. I simply cannot feel optimistic about our long-term financial stability as a nation given the apathy of the political establishment on both sides to do anything meaningful about our deficit. We cannot expect to borrow at 2% yields forever (see: Europe.) We will be in very serious trouble if we find ourselves, all of a sudden, unable to manipulate interest rates.
- Artificially Low Lending Rates: Something that Keynesians refuse to acknowledge, by and large, is that there is risk associated with providing easy access to capital. Low rates make it easier for banks to create enormous amounts of leverage, which is what gets us into liquidity traps in the first place. Really low lending rates reduce the incentive for borrowers to find something worthwhile to do with the money that they have borrowed; additionally, low rates create an incentive to lever up your investments, which leads to increased risk.
- No Incentive for Policy Change: The two issues above work with one another in a positive-feedback loop. The Fed has created an environment that makes it easy for our government to borrow money, so policy makers have a disincentive to restrain money supply growth. Additionally, reversing course to market interest rates would create some economic hurting and probably some disinflation, but it has to happen eventually. These problems won’t simply go away if we ignore them.
- More Deleveraging: Households have deleveraged a fair bit (we’re down to 1993 household debt levels), but we may continue to do so until we reach, say, 1980 levels. If deleveraging is part of a 50- or 60-year macrocycle, then we should expect the credit cycle reversal to take us back to levels before the credit cycle. As evidence that we’re still very much in the midst of deleveraging, I would point to extremely low interest rates in virtually every market. No one wants to take on debt.
- Homes: In spite of massive government interventions, the negative equity problem in home mortgages persists. We’re forcing the market to clear much slower than it would otherwise, so I would expect that we have at least another year of cleaning up to do. (On the policy front, I think that rather than forcing rates even lower, we should just create incentives for banks to lower the principal on the mortgages that they issued. Otherwise the negative equity problem will persists, and the principal of these loans as reflected on bank balance sheets will not reflect the value of the underlying asset.)
I’m not that worried about Europe, because we don’t have a tremendous amount of direct exposure, relatively speaking. (As James Altucher points out, the top 5 US banks are 8% exposed to European debt. In 1981, we were 260% exposed to South American debt.) Granted, though, their crisis will still have the effect of devaluing the dollar through increased US SDR holdings, among other things, but we could be much worse off in terms of exposure.