Michael Pettis of Global Partners Source says it’s all about the debt, dummies. In his January 14th Monthly Report, Pettis argues that that you can print money or use other methods to prime the economic pump all you want, but you’re not going to get sustained growth as long as you’ve got a huge debt overhang.
He specifically mentions Japan, China and Europe as likely to remain stuck in low-growth mode until they find some way to work through their debt.
Michael Pettis describes the “debt trap”
Pettis says the first thing to keep in mind is: “Liabilities are more than simply the sum of the ways in which assets and operations are financed. Liability structure determines how payments are indexed and how an economic entity absorbs and responds to external shocks.”
He goes on to describe how indexing payments, in effect controlling how operating earnings/value creation are distributed, creates “liability structures change incentive structures for investors and managers and determine risk appetite. By setting the response to external shocks, they can create highly pro-cyclical processes that exacerbate both the positive and negative impacts of shocks.”
Also keep in mind that incentive structures and risk appetite impact growth. Pettis notes: “When the economy is doing well, distortions in macroeconomic liability structures can cause growth to exceed expectations, while under adverse conditions these same distortions can reduce growth or even prevent it altogether.”
This means that debt has a significant impact on how economic reforms, however beneficial, translate into growth in the short-term. He explains: “When debt levels are low, a country that implements the “right” reforms will see them translated into higher productivity growth and higher GDP growth. As the debt burden rises, however, debt itself becomes a constraint on growth, so that countries that are perceived to be highly indebted will not achieve anything close to their growth potential.”
Pettis concludes his discussion of debt with a less than sanguine global economic forecast for the next couple of years. “Chinese growth will continue to slow sharply over the next few years and Japan and much of peripheral Europe will not be able to grow at much above 1%, even as credit growth continues to exceed economic growth. Only aggressive policies aimed at paying down the debt, or outright debt forgiveness, will change the growth dynamics.”
Finally, Michael Pettis has an interesting discussion on George Soros’ contribution to macro-economics, which we thought readers would enjoy- below is a short excerpt
George Soros made what I think is an important contribution to economic thinking by working out a process in financial markets he called “reflexivity”, which in mathematics describes a feedback relationship between two variables in which each variable’s output reinforces the other’s input. It turns out that Soros’s reflexivity, which among other things explains the way in which markets substantially overshoot when a constraint that has come under significant fundamental pressure is relaxed, is itself a consequence of balance sheet inversions that have evolved within the investor base.
Before Mexico was forced to devalue in December 1994, for example, or South Korea in November 1997, economists believed that their currencies were overvalued by roughly 20% relative to the dollar. When the peg was eliminated, their currencies did indeed drop, but the dollar’s rise against these currencies was not limited to the roughly 25% that would have restored fundamentals, but rather it shot up by 100-150%, mainly because of the reflexive process in which a depreciating currency forced borrowers in dollars to buy dollars to hedge themselves against further depreciation. But with so much dollar debt outstanding, the very act of hedging forced the local currency to depreciate even further. Each variable in the reflexive relationship, in other words, created a reaction that reinforced the other.
If Spain were to leave the euro, the same balance-sheet structure – in this case the bulk of debt being denominated in euros – that caused the peso and the won to collapse would cause Spain’s new currency to drop by far more than the 15-20% by which most economists believe Spanish costs are overvalued. Spain’s new currency would almost certainly collapse under the pressure of so much external debt were it to devalue. This process would be reinforced by yet another reflexive relationship – as the value of euro debt soared relative to Spain’s newly-denominated GDP, the increasing likelihood of a default and forced write-down would cause bondholders to sell bonds, driving down the price, and the currency, even further.
It shows how poorly understood debt and balance sheets are among orthodox economists that Soros’s reflexivity is largely marginal to macroeconomics, even when it is clearly useful in explaining why economies so often behave in “surprising” ways .
Michael Pettis has more great nuggets – for those who do not have the report check out Pettis’ latest blog post for more excellent macro analysis.