11.07.2012 1

Deleveraging still looms over economy, Obama’s victory

By Bill Wilson In spite of Barack Obama’s victory at the polls on Nov. 6, his incoming administration will still face a daunting challenge as the U.S. economy appears likely to remain in a catatonic state for the foreseeable future. Why?

In decades past, the health of the economy has been closely tied to the rate of credit expansion nationwide. That is, the rate at which banks lend, and consumers and businesses borrow has a direct correlation to the rate of economic expansion.

Typically in a virtuous cycle, as the economy grows, credit too will expand to satisfy legitimate demand — based on an ample ability to repay and a collective set of forward looking appraisals that are positive.

But, if cheap credit is used to artificially boost demand, it usually leads to an unsustainable credit bubble — something that has happened twice in modern history. That was in the 1920s and the debt supercycle of 1971 to 2008.

After the bubble pops, credit expansion grinds to a halt as deleveraging forces take hold. This was the pattern seen in the 1930s. From 1930 to 1933, credit outstanding nationwide contracted 13.8 percent, from $173.1 billion to a bottom of $149.2 billion. During the same period, the economy shrank by a whopping 7.37 percent average rate each year.

Once a bottom was felt in credit markets, starting in 1934 the economy rebounded, at least from a growth perspective, as unemployment remained unacceptably high until World War II. But growth again halted in 1938 when total debt nationwide again contracted slightly by 0.7 percent along with economic growth, shrinking the economy by 3.4 percent in the process.

The correlation is very strong: If credit is not expanding, chances are neither is the economy.

And that is why Obama will have his work cut out for him. Credit outstanding has more or less ground to a halt since 2008, only expanding at an annualized rate of just 1.4 percent to its current level of $55 trillion.

That compares with about 10 percent average annual credit expansion prior to the downturn, going all the way back to World War II. The amount of debt nationwide has doubled every decade like clockwork. The only exception was the 1930s.

In other words, credit markets are in as bad a shape as they’ve been since the Great Depression. Despite policymakers’ efforts to bail out banks, they have not avoided another depression.

The primary driver of deleveraging at the moment is still in the financial sector, where debt has contracted from its $17.1 trillion level to $13.8 trillion today, and still getting smaller. As the CEO of Pimco, the world’s largest bond trader, Mohammed El-Erian notes, the economy is still trying to “find a way to safely ‘deleverage.’”

“We must overcome the many years during which policymakers lost sight of sustainable drivers of growth and jobs and instead ended up relying on excessive leverage, overindebtedness and an absurd sense of credit entitlement,” El-Erian explained in a recent Washington Post oped explaining the “new normal,” a term he coined.

Compare that sobering assessment with Bloomberg News’ Rich Miller and Steve Matthews enthusiastic prediction that “the economy is on course to enjoy faster growth in the next four years as the headwinds that have held it back turn into tailwinds.”

What of credit expansion? “[B]anks are increasing lending after boosting equity capital by more than $300 billion since 2009,” Miller and Matthews report. Except, capital requirements — the amount of money banks must have on hand to lend — have also increased per Basel III and Dodd-Frank.

In order for credit to expand at the rate it used to, banks will have to raise $500 billion in new capital — every single year.  We’re nowhere near that now, so Miller and Matthew’s optimistic appraisal will likely fall short.

Slate’s Matt Ygelias declares Obama to be very lucky because he is “poised to preside over a return to economic normalcy that’s bound to make any kind of basically competent governance look fantastic compared to the last decade of misery.”

Based on what? Writes Ygelias, “[O]ver the past 18 months, the economy has added an average of 162,000 jobs per month. Simply holding that current trend steady for four years without any improvement in underlying economic policy would give us 7.8 million jobs.”

That may be so, but there’s a problem. The working-age population has been growing by 249,000 per month over the past 18 months. So, if the economy continues to only produce 162,000 jobs a month, at best unemployment will remain unacceptably high — just as it did in the 1930s.

So, the depression will continue. Here’s something for Obama to consider: Let the deleveraging occur without any more bailouts, and get it over with as soon as possible. The sooner the bad debt can be squeezed out of the economy, the sooner the virtuous cycle of growth can be restored.

Bill Wilson is the President of Americans for Limited Government. You can follow Bill on Twitter at @BillWilsonALG.

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