Investing During Unsustainable Economic Conditions
May 1, 2012
While it’s certainly possible it could work out that easily, a look “under the hood” of the recovery from the recession reveals a starker view. The recovery of GDP in the previous chart is in large part due to the substantial increase in deficit spending by the federal government, which has acted as counterbalance to the deleveraging private economy. If we subtract government spending and the effects of inflation from the blue GDP line in the previous chart, we are left with the red line in the chart below – which approximates the private economy. The purple line shows the federal debt as a percentage of the private economy.
While total GDP has recovered to new highs over the last few years, the level of private economic activity today remains mired below its 2007 peak. Despite the vast increase in debt the government has incurred in its effort to stimulate the economy, it has only just been enough to counter the underlying weakness in the private economy. Without this perpetual borrowing and spending by the government, the economy would begin contracting again.
If this need for continuous borrowing just to keep GDP from contracting sounds familiar, it’s because it is precisely the dynamic seen near the end of the housing bubble and just prior to the meltdown in Greece. In the end, the use of ever-increasing amounts of debt to prop up an asset class or to keep an economy levitating above where it would settle of its own accord can only last for so long. Eventually, the process collapses under its own weight.
While it may be some time before the rising federal debt starts to have an impact on the real economy, the financial markets will start to react long before that becomes apparent. During the housing bust, the market for the riskiest mortgage debt started to dry up in early 2007, before the stock market peaked, before the recession began, and more than a year before the peak of the credit crisis in the fall of 2008.
The same has been true in Europe, as the markets began balking at buying Greek government bonds at low rates back in 2009, more than two years before Greece actually defaulted. However, that delay only marginally helped the Greek stock market, which fell 73% during the recession of 2007–2009, before declining another 79% from late 2009 through the end of 2011 – even as the bailouts came in. The markets often find comfort in pushing off hard economic choices, but sometimes the markets begin to recognize an unsustainable financial trend and react well ahead of the eventual crisis. However, that “recognition point” is impossible to predict.
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