Stephen King: Marshlands of debt may sink global recovery

'Either policy will deliver a soft landing or the markets will impose their own solution'
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The Independent Online

The most spectacular buildings don't amount to much if they have weak foundations. They might look impressive for a while, but if they're built on marshland, they're likely to fade from view rather too quickly.

The same applies to economic recoveries. Strong, sustainable recoveries need to be built on good foundations. The latest global recovery, though, appears to have weak foundations. It's built on marshlands of debt. As interest rates rise, these marshlands will come under extreme pressure.

A number of oddities support this view. These oddities don't fit easily with hopes of a healthy recovery. Instead, they're signs of risk, of dangers that could trip up even the most well-intentioned of policy-makers.

The first oddity is the valuation of equity markets. The left-hand chart shows the price/ earnings (PE) ratio of the US equity market going back to the 1870s. Equities are quite a lot cheaper than they were at the peak of the bubble in 2000. But they're still a lot more expensive than at virtually any other time in the last 130 years. Put another way, equities today offer the same kind of excellent value that was available in 1929. To my mind, this doesn't feel quite right.

The second oddity is the valuation of housing. Over the last two or three years, housing valuations in the US and the UK have become very stretched, so much so that they now look more expensive than in any other recent period of history. The right-hand chart shows the US perspective: the UK version looks even worse.

The third oddity is the scale of macroeconomic imbalances. The US current account deficit is bigger than ever. Yet most US recoveries take place when the current account deficit is small, not when it has taken on gargantuan proportions. The growth of the current account deficit tells us something about attitudes towards leverage. Companies in the US may have de-leveraged but, for the economy as a whole, attitudes towards debt really haven't changed a bit. Consumers and the government have simply borrowed more.

These three oddities suggest that bubbly behaviour still persists. People are still prepared to pay more than before for owning equities. They're prepared to pay a lot more than before to own houses. And they're prepared to carry on borrowing in ways that we've never seen before.

At a pinch, it might be just about possible to justify this behaviour. Those who seek to do so rely on two arguments. First, they point out that we're seeing a supply-side revolution which is transforming the world economy, driven by new technologies and the arrival of new economic powerhouses such as China. If this means stronger long-term growth, that might justify higher asset prices today than in the past.

Their second argument relies on the observation that interest rates are quite a lot lower today than they used to be. A lower discount rate justifies higher asset valuations - hence more expensive shares and houses - and also paves the way for higher sustainable levels of debt.

These arguments are all very well but, in my view, they don't really make an awful lot of sense, particularly when they're combined with each other. Interest rates are lower today than they were in the Seventies and Eighties partly because inflation is a lot lower. That means that nominal wage and profits growth will also be lower. And, once this is taken into account, it becomes a lot more difficult to justify stretched asset valuations.

Real, inflation-adjusted, interest rates are also relatively low, partly because of the easy monetary stance of many central banks. Could this be used as a way of justifying higher asset valuations? It would be nice to think so but, if you think about it, it's simply not possible to sustain this argument. Supply-side improvements in the global economy that point to stronger economic growth also require higher real interest rates because capital will be in greater demand. To claim that real growth can be higher and that real interest rates can be lower is simply not a tenable position. And if that combination is helping to sustain asset prices at these high levels, there's a potential accident waiting to happen.

How can this situation be resolved? If asset prices are still too high, if debt levels are too high and if countries are borrowing too much, what are the potential solutions?

Broadly speaking, there are policy-driven solutions and market-driven solutions. Of the policy solutions, the most obvious is higher interest rates. However, if expectations within asset markets are inconsistent with future reality, interest rates are in danger of being a blunt instrument. Rates went up only modestly in 1999 and 2000 but the damage - in the form of the stock market crash and the subsequent recession - was a lot worse than central bankers had hoped.

Then there's exchange rate depreciation. A policy of dollar weakness could have two potential benefits. First, it would be a way for the US to default to its foreign creditors (who, perhaps unwisely, have lent to the US in dollars rather than in their own currencies, thereby leaving them worse off if the dollar falls in value). Second, by lifting domestic inflation, a weaker dollar might help reduce the debts in real terms of those people who could begin to regret the amount they've borrowed over the last few years.

This is all very well, but the problem with these policy-driven solutions is their potential interaction with market-driven solutions. At this point, life gets complicated. Let's say that the Federal Reserve shoves short rates up. How can it prevent an even bigger rise in long rates - as in 1994 - that might seriously destabilise both housing and equities? Alternatively, let's say that the markets get a whiff of policy-induced inflation. At that point, the benefits of the policy unravel because risk premiums on assets would rise rapidly, undermining the ability of the central bank to bail out debtors.

Ultimately, if there's been too much borrowing, and asset prices are inflated, it is quite difficult to escape from the conclusion that there has been excessive spending, a process of "borrowing from the future". Of course, if the productivity miracle is even more impressive than we all expect, then today's debts and asset valuations might ultimately be justified. This, though, doesn't seem like a terribly good bet. Equities, for example, still look rather pricey on a PE basis despite a major recovery in profits over the last 12 months, which should have done a lot to remove excess valuations.

So, either policy will have to do its work, deflating expectations in the vague hope of delivering a soft landing for the global economy, or the markets will impose their own solution. Sadly, any market solution is likely to be rather unpleasant - currency turbulence, falling house prices and declining share prices. Yet these are the prices that we might eventually have to pay for our collective refusal to allow the bubbles of recent years fully to deflate. It might have been an impressive recovery so far, but the marshlands of debt upon which it is built may eventually bring the whole structure crashing down.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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