Economists know that there are three ways to deleverage an economy: austerity – where debt growth is held below the rate of economic growth; restructuring – where bad debts are written down or renegotiated; and monetization – where money is printed to make lenders whole at broader expense. In this regard, Ray Dalio of Bridgewater has good-naturedly called the recent experience a “beautiful deleveraging” because it has involved some mix of all three. But it is precisely that beauty that has made it so ineffective, as the global economy and the global banking system have hardly deleveraged at all in the wake of the last credit crisis. The insufficiency of restructuring measures and the excessiveness of monetary interventions have combined to create an environment of moral hazard where increasing debt burdens have been tolerated without durable concern. The hard decisions have been put off to the point where the size of the problem is likely to overwhelm the ability of hard decisions to address it without a crisis.
The key question is whether the absence of an obvious recession should be taken as an indication that the deterioration in income and output growth can be ignored – in effect, whether we should assume that this time is different. From our standpoint, the evidence from a wide variety of economic series, including but not limited to broad measures like GDI and GDP, continues to indicate that the U.S. economy most likely entered a recession in the middle of this year.
I want to emphasize that I don’t hope for a recession – that is just the conclusion that I believe the best reading of the evidence supports. Sure – if there is no recession, I clearly would rather not have warned of the risk, but I would still prefer to avoid a recession even though that’s what our analysis indicates. It would be a relief to see the data shift away from a recessionary pattern in a durable way, and I would be happier still for stock market valuations and market conditions to support a significant exposure to market risk. Both of those will arrive, but they are not here at present, and I expect there will be some downside first. Our economic challenges will be addressed in time, but they are likely to involve much greater restructuring and much slower progress on deficit reduction than the capital markets seem to contemplate. Europe will solve its problems, but most likely through a departure of stronger countries from the Euro, followed by a combination of aggressive restructuring and monetization. We will get through all of this, and both the economy and the financial markets will do fine in the longer-term, but to imagine that there will not first be major challenges and disruptions is a leap of faith – and a leap over a century of economic and financial history that screams otherwise.