I described bottom fishing in banks several months ago as a particularly dangerous extreme sport, suitable only for adrenaline junkies. Now, we have reached a defining moment in the cascading implosion of the global financial system, with investors in Europe in recent days increasingly taking the view that large scale (if supposedly temporary) nationalizations are inevitable to tackle the effective insolvency of many leading institutions. We've already seen $1trn in writedowns from financial institutions globally, who after capital injections from private and state sources have aggregate capital of about $1.4trn (or 10% of US GDP). The danger is that this capital cushion could be wiped out as write-offs surge in 2009/10 due to the brutal cyclical slowdown. In Germany alone, according to the banking watchdog BaFin local institutions face a further $300bn in bad debt write-offs.
It seems that the incoming Obama adminsitration will announce radical new initiatives within days to 'inoculate' banks from their most toxic derivative exposure and kick-start the credit system. It will be the last chance to save the private US banking sector before a Federal conservatorship such as was used with Fannie and Freddie becomes a last resort. A key problem with efforts to address this crisis is that they are not reducing unsustainable levels of aggregate leverage in countries like the US and UK, but simply transferring the burden from the private to public sectors.
That is understandable, to the extent that slashing consumption and investment in order to pay down debt would lead to soaring unemployment and 1930's style real output losses, but short of monetising the debt aggressively via inflation (which I believe will be the inevitable medium-term outcome) there is no remotely easy or rapid way out of our accumulated imbalances. So what are the policy options and implications for investors? The charts below illustrate the enormous scale of the leverage mountain now sliding down on our heads. The first chart shows the growth in US nominal GDP against the growth of the financial sector (represented by the total of credit market derivatives outstanding). The explosive growth of high finance relative to the economy at large began an exponential rise from the late 1990's.
The second chart shows that while GDP has risen 8 fold since 1975, public sector debt had risen 11 fold, and private sector debt has grown an astonishing 22 times. Simply put, the basis of growth over the last decade, dependent on ever increasing volumes of debt, was utterly unsustainable. The Subprime debacle may have been the specific trigger, but the bubble in leverage would sooner rather than later have collapsed regardless.
In most of the post-war period, debt grew at about the same rate as nominal GDP, so gearing levels for the economy at large remained pretty constant. Whether because of the slowing of innovation I have commented on previously or a host of other factors, 3-4% real GDP growth rates have been achieved only by hosing the economy with ever increasing and systemically risky levels of debt. The problem is that debt, like any input, suffers diminishing marginal returns. The future outlook is for much lower real growth rates (1-1.5% for many years) and higher inflation (reaching mid single digits over the next few years). Call it Stagflation if you wish, but it's going to feel very uncomfortable for those who haven't anticipated the new reality. This strategic outlook informs my view that long-term investors should be accumulating inflation hedges such as TIPS and real asset exposure such as resource equities on periodic market weakness through 2009. Whatever the rhetoric, and however unjust it may seem, the debt burden will be spread by inflation from the profligate and reckless to the responsible and solvent, because that is the most politically expedient course.
