Dear Valued Clients and Friends,
I gave a speech this week at a large economic symposium where I am blessed to lecture every summer. My talk tackled many of the themes I write about all the time in the Dividend Cafe – the impact of excessive indebtedness on macroeconomic conditions, the comparison of pre-GFC Japan with post-GFC America, the diminishing return of fiscal and monetary policy to impact the business cycle, etc.
This week’s Dividend Cafe takes all these themes and lessons of so many Dividend Cafe bulletins and puts them together the way I presented them at my speech this week.
We have included a link to the presentation deck as well in case having that deck accessible will be of interest going forward.
And most of all, I have tried to incorporate some suggestions of what could change it all – not what will change it all, but what could.
So jump on into the Dividend Cafe. From Grand Rapids, Michigan, to the Big Apple, Japanification is real. And the impact of debt on growth is the most misunderstood or ignored economic reality out there.
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How to read this week’s Dividend Cafe
Truth be told, if you are reading on your desktop, it may be easiest to open this presentation deck so as you are reading, you can go back and forth between the charts that have been created. But since I know a lot of you may be reading on your phones, it may be more impactful to read the deck separately from this written content. But who am I to micro-manage how you take it in? I don’t believe in central planning much, and that includes a command-control dictum for how one reads the Dividend Cafe. Let’s just say that the deck has a lot of visual reinforcements of what I am saying here.
A Tale of Two Nations
The fundamental framework I have believed in for quite some time is that a wide array of American economic life post-financial crisis is similar to what Japan experienced and delved into long before our financial crisis (what you might say was post their financial crisis). The deflationary stagnation in Japan for decades now came in the aftermath of their massive asset bubble implosion post-1989. The similarities between Japan and the U.S. in national debt, in certain aspects of demography, and in the results of policy prescriptions are pretty surreal.
As I have written in Dividend Cafe many times, the essence of Japanification is in how a country responds to the economic damage created by an asset bubble bursting. An isolated or non-systemic bubble burst is reasonably immaterial here. Over $2 trillion was set on fire last year when crypto melted down, but the only people it hurt were the speculators holding crypto. Plenty of asset classes or investment sectors have gotten overheated in a moment of “shiny object” allure and then melted back down to planet Earth. It is only when that experience becomes contagious – where the aftermath of it impacts more than just those risk-takers holding the asset in question – that this becomes relevant.
The economic damage of a broader bubble bursting includes things that are generally very problematic in a society socially and politically – most notably, a significant decline in wages, jobs, and profits. In the most severe of these moments, a debt-deflation spiral forms where things are worsening as the debt is being paid down because the level of assets and wages is falling quicker than the debt can be reduced, meaning each dollar of debt reduction is actually making the society poorer because the asset base is declining more (see: Irving Fisher). It is not a fun thing to live through (see: Great Depression).
To counteract the economic damage that takes place from the bursting of a systemic asset bubble, countries have defaulted to the use of Keynesian fiscal spending to offset the damage, accompanied by central banks using various monetary policy tools to soften the pain. The monetary policy tools lower the cost of capital, which incentivizes more borrowing. Additional borrowing (debt) puts more of a drag on growth. More borrowing and spending means less savings and investment. And in all of this, the very thing one is trying to remedy (damaged growth from economic contraction) is what suffers the most (more damage to growth).
All of it is rooted in the use of debt and leverage.
State of the Nation
The U.S. had a debt-to-GDP ratio of 36% in 2006 (using just public debt – meaning excluding debt one side of the government owes another side of the government). That number is roughly 110% now. The 2006 level had gone to 66% by 2011, nearly doubling through the financial crisis (behind increased debt as a Keynesian policy tool in the GFC and a declining GDP from the impact of the recession; this is always the case, by the way – a debt-to-GDP ratio blows out both from a higher numerator (debt level) and a lower denominator (GDP size). But then through eight years of peace time and economic growth and recovery, we somehow pushed the ratio from 66% UP to 79%, all pre-COVID. And then, post-COVID, we ended up at 110% debt-to-GDP (again, just using debt held by the public). The debt that includes inter-governmental debt obligations is closer to 125% of GDP.
The reality of $32 trillion of debt is coupled with the reality that we add another $1 trillion per year to that number (sometimes more). The government spends a very small amount of annual expenditures on debt service (relatively speaking) but rather has a sizable obligation in the form of mandatory health care programs and entitlements, etc. The transfer payment commitments in one form or another have become 60% of annual outlays. There is no politically easy or socially pain-free way to address any of this. There just isn’t.
Growth is the sacrificial lamb
We have been living with 1.6% real GDP growth annually since the Great Financial Crisis. We had been living with 3.1% growth for the seventy years before that. Annual economic growth, net of inflation, has been cut in half since the financial crisis. And this is the price we have agreed to pay for the excessive spending and debt load we have taken on.
Real (net of inflation) per capita (population-adjusted) GDP growth has meant a substantial decline in the standard of living versus our trendline growth and expectation. That gap in what has become a reality for per-person economic growth versus what post-war expectations and trends called for is a highly plausible explanation for much of the social and political divide in present conditions.
Growth flows out of increases in productivity, and increases in productivity require investment. But, of course, investment requires savings. Less aggregate savings is the mathematical inevitability of higher aggregate debt. Consequently, net domestic investment as a percentage of GDP has declined from nearly 12% fifty years ago to barely 4% today. We are tempting fate in many ways.
The measurement of growth
Bond markets around the world have all loudly testified to the truth at hand: Higher levels of indebtedness put downward pressure on growth. Bond yields in the United States, the European Union, Japan, and the UK have all collapsed in the last 25 years as spending and debt have exploded.
The U.S. ten-year bond yield sits at 3.7% or so right now and has not been able to hold above 4% even through the entire inflation of 2021 and 2022. Trillions of dollars of free people are voting on virtually no inflation/growth in the U.S. in the years ahead. TIP spreads reflect expectations of 2% annual inflation.
Markets are powerful measurements of reality.
Plan B – Monetary Medicine
So the response to various economic headwinds has been heavy use of fiscal stimulus, and the response to a changing vision of our social democratic society has been a larger size of government within the economy. As these things have run their course in terms of economic utility as well as affordability, the next step coincident with them has been a central bank ready and able to play doctor. Yet what has been the outcome of years and years and years of hyper-accommodative monetary policy (until the last nine months)? Loan demand collapsed. The velocity of money collapsed. And the identical thing that played out in Japan played out here – monetary policy is subject to the law of diminishing returns just as fiscal policy is.
The monetary policy did not serve to hyper-inflate as the quantity theory of money gave us the reason why – while the money supply increased, velocity decreased, negating the impact on the price level. Yet as good borrowers and good things to borrow money for went first, the ending sequence left the economy over-levered, subject to bad investment, and incentivized to not produce new things.
As was the case in Japan, the lesson of interventionist monetary policy in the states was not inflation, but worse: Malinvestment, Distortion, and Speculation. Unsustainable moves higher in housing in 2020-2022 have led to an affordability crisis in housing, even as sky-high interest rates relative to what people have locked on their current homes as led to a collapse of housing transactions, period.
Cra-cra
The result of monetary manipulation of the cost of capital has been instability. As I have written in Dividend Cafe countless times, interest rates that are unnaturally high slow economic growth as resources are diverted from productive activity to interest
payments, but interest rates that are unnaturally low create rampant speculation. Finding the natural rate (that which neither slows nor accelerates economic activity – the growth rate of nominal GDP) is not something a group of people divorced from rules and principles can arbitrarily do. When they try to purposely move above and below a natural rate to effect economic activity, it leads to financial instability.
Japan as the model
I will quote from the Dividend Cafe just three weeks ago:
(1) The government has borrowed so much money they need very low rates on the debt
(2) Very low rates on bonds keep foreign investors and/or domestic savers away
(3) A lack of foreign investors and domestic savers to fund the bond market makes the central bank have to do more
(4) The more the central bank does, the more interest rates are kept near zero
(5) A lack of capital flows means a lack of investment, a lack of productivity, and a lack of growth
(6) A lack of growth means more government spending and borrowing
(7) More government spending and borrowing means the need to keep rates low, which means … (start this list all over again)
Japan’s central bank is essentially half of their bond market now, while the Fed is less than 20% of our own. But the hyper-present role of the central bank in sovereign debt issuance is distortive, clamps down growth, and leads to the need for greater medicine still in the future.
Demography
I do not believe the only area where we have followed Japan’s path is an asset bubble, a fiscal and monetary interventionist response, and a collapse of growth as a result – we also are following the demographic path, albeit at a much slower pace (thank God). We averaged about 2.1 kids per household for most of 1990-2010 and now have fallen back to a 1.7 level, leading to an eventual downward decline in productivity (when the prime working age group is filled with fewer people than it currently is). Japan went through that much more severely (a fertility rate half of that), but the point is the same: Population growth and productivity are needed for economic growth (this is a tautology), and we are shedding both, just as Japan did.
In summary
Excessive indebtedness leads to policy actions that put more downward pressure
on growth, which leads to more fiscal and monetary measures that exacerbate further.
Excessive Debt = Low Growth = Policy Actions that create more debt and lower growth
What will we do?
I expect our only path to be Japanification – sacrifice growth versus other (also painful) measures that seem less politically viable. Japanification itself does not have a final act written – as the story there is only limited by a failure of imagination, just as is the case here. They have done Yield Curve Control, they have done Negative Interest Rates, they have done full central bank monetization of risk assets – and they are still floating along figuring what is next, not insolvent, not with a failed currency, and yet growing a whit in thirty years.
Our own creativity to break rules and norms with the objective of more aggressive monetary and fiscal interventions is under-estimated to our own peril. Mark my words.
What should we do?
Repent, for one, but if that is too proselytizing for you, then at least change.
The first change is to stop digging into the fiscal ditch we are in.
Balance the budget, pronto, no matter what pain it creates.
For that to happen, Congress will have to do its job. Good luck with that.
The Fed needs to be right-sized as a lender of last resort, not the doctor of the business cycle.
And the people need a resurgence of self-government out of this fifty-year crisis of responsibility. Strong self-government is inversely correlated to excessive indebtedness. Therein lies the rub.
Quote of the Week
“Everyone must choose one of two pains: the pain of discipline or the pain of regret.”
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I hope this deck and recap of this sobering message were helpful. Next week may cheer you up a little more! There is an opportunity worth discussing.
Have a wonderful weekend!
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
