Debt without Growth

Much has been made of the fact that the last seven years have seen one of the weakest economic recoveries from recession on record. Not only has real growth been relatively low in this recovery but inflation has also remained consistently low. The two together comprise nominal (or money) GDP, which is the growth rate of the economy in actual money terms, and is what businesses and consumers experience directly. In the UK real growth of 1.5-2.0% is coinciding with inflation of near zero, so that nominal growth has been less than 2%. This compares with typical nominal growth rates of 5-6% before 2007.

This appears to be following a worryingly similar pattern to the Japanese economy which since the early 1990s has seen average real growth of about 1% and inflation of minus 1% giving zero nominal growth over the last twenty-plus years. Such stagnant nominal economic growth, if it goes on too long, affects expectations about the economy. When companies and households expect no or very little nominal growth, they lose confidence in future economic opportunities and do not seek to invest to benefit from such growth or seek to spend since there is a fair chance that purchasing anything will be cheaper in the future and they have little confidence that their revenues or pay are likely to rise in the future.

In such conditions debt becomes a huge burden as it is a fixed nominal sum. If it was taken on with expectations of nominal growth of 5% per annum, but in fact there is very little nominal growth, the cash flow to service the debt is harder to find. The rational behaviour of economic agents is thus to save and pay down debt, further constraining the level of demand in the economy and creating a negative feedback loop.

This process terrifies central bankers for while they all know how to get inflation to fall if it is too high, they do not possess safe tools to get inflation to rise when it is too low. Thus we have been in a world of first low interest rates, then zero interest rates and now negative interest rates and several rounds of QE where money has been pushed into the financial system. By and large these have failed to get inflation rising again though financial market assets have seen price inflation. Since the Global Financial Crisis, government deficits have continued to lead to more debt being issued while companies have also increased debt, not to invest productively but in order to buy back equity. Debt has continued to grow but economies have not kept up

There are only three ways to get rid of any debt burden – Deflate, Default or Devalue. “Deflate” means to spend less than your income to provide the savings to repay the debt – this is fine for individual borrowers, but troublesome for the economy when pursued by governments or many borrowers at the same time. “Default” means not repaying – a terrible solution for the lenders who will reduce their own spending to compensate and also become far less keen to lend again in the future. Since the first two are very unattractive options to policymakers, their preference is usually for “Devalue”. This means apparently repaying the debt but doing so with money that has far less value. There are two routes to achieving this, first (for governments) by letting your currency fall on the foreign exchanges and second by creating inflation so that the real value of the debt repayment is much less. A good way to achieve both routes is to create a lot more supply of your own currency.

So the global economy finds itself in a real bind – weak growth has meant that the debt burden has increased and this has ensured that weak growth will continue. Policymakers have so far been unable to break free of this cycle.

For investors, the key actions are to be prepared for continued low growth and low inflation – which means low returns from all asset classes – until such time as policymakers panic and decide to get serious about creating inflation to devalue the global debt burden. At that point bonds and cash will lose a lot of real value and gold will find itself in massive demand as the inflation hedge and the only currency that politicians cannot create at their discretion.