Stephen King: US economy needs rehab for debt addiction

'We could be entering a very odd phase. We really cannot be sure what will happen when interest rates go up'
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The Independent Online

I've just come back from a whistle-stop tour of the US, heading backwards from the west to the east coast before finally heading home over the weekend. The US economy feels vibrant. The data have, for the most part, been buoyant. Yet people still appear to be anxious. Although the economy has performed better than feared, the fear itself seems not to have fully dissipated.

I've just come back from a whistle-stop tour of the US, heading backwards from the west to the east coast before finally heading home over the weekend. The US economy feels vibrant. The data have, for the most part, been buoyant. Yet people still appear to be anxious. Although the economy has performed better than feared, the fear itself seems not to have fully dissipated.

It's almost as if Americans are pinching themselves, not quite ready to believe that they might have got away with one of the biggest stock market bubbles of all time. Yes, there was a recession. Yes, there were job losses. But at no point did the feared meltdown in economic activity ever take place.

One possible reason why this never happened, perhaps, could be the famed flexibility of the US corporate sector. Whereas the Japanese scratched their heads, pondered, considered, worried and ultimately did very little, American businessmen and women were quick to recognise the error of their ways and do something to improve the situation. On top of the advances in productivity and profitability (which, to be fair, helped the corporate sector only at the expense of the labour market), the most impressive feature of the American business climate has been the huge amount of de-leveraging.

Companies that became debt dependent, that became credit junkies, have successfully gone through rehab. The left-hand chart, for example, shows what is known as the "financing gap" - the amount of money that companies need to borrow for investment purposes each year over and above what they have in the form of "internal funds". At the peak of the bubble and beyond, the financing gap was enormous. In a very short space of time, though, the gap disappeared. Companies now appear to have too much cash and are beginning to splash it around again. It's no surprise, then, that capital spending has picked up rather strongly.

Yet there's something a little uncomfortable about this story. The US corporate sector may have de-leveraged, but the economy as a whole most certainly has not. One easy way of showing this is through developments in the US balance of payments position. The right-hand chart shows the US current account surplus or deficit as a share of total output all the way back to 1960. The vertical bars on the chart represent periods of recession.

The current account position can be regarded as an overall measure of a country's need to borrow (or, alternatively, the rest of the world's willingness to lend). The bigger the current account deficit, the more funds are pouring in from abroad. If a country as a whole is in the process of de-leveraging, it would be reasonable to expect the current account deficit to be reduced - or to disappear altogether.

In the past, the US has been rather good at delivering this result. In all economic downswings over the past40 years, the current account deficit has disappeared for at least a short space of time. But not on this occasion. The deficit did shrink a little bit during the 2001 recession and the initially weak subsequent recovery, but this move was peanuts relative to earlier adjustments. And the deficit then expanded to new record highs.

This is another way of saying that US policy makers have dealt with the corporate leverage problem through a cunning plan: creating leverage elsewhere. For every dollar of debt reduction in the corporate sector, there's been more than a dollar's increase elsewhere, either through additional government borrowing or more consumer leverage.

Imagine a marriage based on this approach. "You know those nasty letters from the credit card company? Well, dear, don't worry. The bailiffs won't be after me anymore. I've paid off my debts."

"Oh really, darling? How fantastic. How did you do it?"

"Honey, I gave them to you."

The US as a whole has not de-leveraged. If it had done, the current account deficit would have fallen quite a long way. So, although the corporate sector appears to have done rather well, the increase in leverage elsewhere takes a bit of the sparkle off the corporate story.

Indeed, it may be that companies have de-leveraged without really having to try too hard. Often, it's a real slog, a period of gut-wrenching pain, to pay down debt, but if, on this occasion, the government and the consumer have come along and simply taken the debt away, the achievement no longer seems quite so laudable. Put another way, company debts may have fallen not because of the tough qualities of the average American CEO but, rather, because corporate revenues were boosted by the aggressive borrowings of the American government and consumer.

This, I think, is a bit of a problem. The strength of demand and the corporate de-leveraging that have simultaneously occurred over the past two years appear to have placed the US economy on a more secure footing. Yet, if the late-1990s bubble left a legacy of excessive leverage, that excess has not gone away: it's simply been redistributed. And, because of that, it might suggest that the underlying foundations of the economic recovery are built on rather fragile ground. If, mistakenly, people believe the foundations really are strong, they're likely to borrow even more. Which means that, for the US economy as a whole, rehab still hasn't happened: the addiction to debt is still very much there and the associated vulnerabilities are still there.

The Federal Reserve is well aware of these risks. It sees greater leverage as a price that was worth paying to avoid deflation, a serious threat over the past two or three years. Oddly, though, the worst kind of deflation - debt deflation - is precisely the result of excess leverage so, ultimately, there's a disturbing irony about dealing with deflation through the build up of even more debts.

The Federal Reserve will tread very carefully when raising interest rates. Think of the FOMC members as the Billy Goats Gruff. They can see the verdant pastures on the other side of the river but know very well that in their way stands a very unpleasant troll that has taken the form of excessively high debts. The Billy Goats Gruff, of course, didn't provide their troll with additional food before crossing the bridge. The FOMC, unfortunately, did: the debt troll is now a lot bigger than he was at the height of the late-1990s boom.

This, in turn, suggests we could be entering a very odd phase in the development of the US economy. Cyclically, the arguments in favour of higher interest rates appear to make a lot of sense. Structurally, though, the higher debt levels today suggest we really cannot be sure what will happen when interest rates go up. And because of that, it's just as plausible to argue that initial rate rises could be followed by hurried rate cuts as the troll awakens from his slumbers.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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