Updated: 06-20-2016

What Ails the Global Economy?
Updated: 10-Jun-16  04:34PM ET
Analyst: David Kelland

The German 10-year Bund yield touched 0.00% on Friday and the U.S. 10-year Treasury yield fell to 1.64%. The West is starting to look more and more like Japan, with the University of Michigan's long-term inflation expectations falling to 2.3% in June, its lowest since records began in 1979. U.S. stocks sport high valuations but much of that premium may be based on low interest rates and low volatility. What is wrong with the global economy?

Shortly after the global financial crisis, I came across the balance sheet recession theory proposed by Richard Koo, the chief economist at the Nomura Research Institute. The concept is that when firms have borrowed money to buy assets that have subsequently depreciated sharply, they become technically insolvent. That leads them to pursue debt reduction rather than profit maximization as a guiding principle. The theory's greatest strength is that it helps to explain the impotence of monetary policy in the face of the Great Depression, Japan's Lost Decade(s), and the aftermath of the Great Recession. If firms are trying to minimize debt rather than maximize profit, then access to very cheap money would not entice them to borrow more. The balance sheet recession concept could also explain how the world exited the Great Depression via military spending for World War II.

There is also evidence of a lack of demand for loans during the Great Depression. The Federal Reserve has taken much criticism - some of it from none other than former Fed Chair Ben Bernanke - for raising interest rates in the early 1930s. What those early central bankers saw, however, was a buildup of excess reserves in the banking system that could unleash high inflation if it was ever borrowed.

Andrew Smithers of Smithers & Co. says we are not in a balance sheet recession. In his 2013 book, The Road to Recovery, he blames equity-based executive compensation for low levels of corporate investment. According to Smithers, if the balance sheet recession were really the problem, why would corporations in Anglo Saxon countries be aggressively buying back stock? Stock buybacks do not repair one's balance sheet. The buybacks do make sense, however, if executives are loathe to make risky investments with long time horizons rather than produce incremental gains by cutting costs. That behavior does make sense in light of the proliferation of equity-based compensation packages. Those pay packages encourage conservative strategies like pursuing incremental revenue growth through price increases and cost cuts through offshoring, rather than risky strategies for aggressive growth.

A third possibility is simply that there are no good investment opportunities to pursue - the secular stagnation theory proposed most famously by Robert Gordon in his 2016 book, The Rise and Fall of American Growth. This is a theory that has been popular in the news and the blogosphere lately, but could just be a reflection of negative sentiment.
In any case, the first two books are good reads and I anticipate that the third one will be as well.

- David Kelland, Briefing.com



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