The Real Deal or An Economic Mirage?

Business woman with financial symbols around

Take a look at the following recent headlines:

Shopper-led economic recovery.
Green shoots starting to sprout.
Housing approvals up.
House prices tipped to keep rising.
Share market to rise again in 2014.
Australian dollar stronger on economic outlook.
GDP growth rate higher than forecast.

GDP growth rates in Australia are within a whisker off the pre-GFC levels. The economy is on the cusp of the ‘good ole days’.

If you believe the headlines above, the medicine has been taken and now the patient is on the mend.

The recent cautiously upbeat economic outlook will have many a household, small business, banker and politician breathing a huge sigh of relief. Who wants another five years like the last five?

The sceptic that lies permanently within me continually asks ‘is it the dawn of a new era of renewed growth, or a government sponsored mirage?’

Perhaps it’s a case of a ‘little knowledge’ being dangerous, but the reasons for questioning the headlines are many.

To appreciate why the newfound optimism may be a false alarm, you have to wind the clock back several decades and step back from the trees to see the forest.

The removal of the gold standard in 1971 rendered all previous constraints on money creation and credit growth null and void. Free from the gold anchor, paper money multiplied and drifted to all corners of the globe. A new economic paradigm was created by Nixon’s infamous decree on August 15, 1971.

Prior to the abolition of the gold standard, people saved. Those savings were in turn used to finance the productive capacity in the housing and manufacturing sectors.

The following graph (courtesy of GMO) shows real (after inflation) US GDP growth from 1880-1980 averaged an impressive 3.3% per annum.

The fingerprints of the industrial revolution and access to cheap oil are all over this extraordinary period of growth.

click to enlarge

In 1974, renowned economist Hyman Minsky released his ‘Financial Instability Hypothesis’. Minsky’s theory in simple terms was ‘stability is inherently destabilising’.

People start taking things for granted and continue to up the ante. The longer the system appears to be accommodating the increased risk taking activity, the greater the risk taking becomes. It’s a self-feeding loop of positivity — until it isn’t.

The GMO graph is evidence of Minsky’s theory. The stability afforded by a century of 3.3% growth led to a belief in the western world that this is how it has always been and will continue to be.

The western world — freed from the pesky gold standard — cashed in on the productivity of its forefathers.

The US was the leader of the pack. The following chart (courtesy of FRED — Federal Reserve Economic Data) on Total US Credit Market debt since 1971 shows just how warm the embrace for credit has been.

Growing from around $2 Trillion in 1971 to just under $60 Trillion today — a near 30-fold increase. During the late 1970s/early 1980s interest rates soared above 15%. This high cost on borrowing acted as a governor on debt expansion.

After Paul Volker (Greenspan’s predecessor at the Fed) snapped the back of high inflation and set interest rates on a path to lower levels, debt levels started to rise.

Every action has a reaction — lower interest rates leads to higher debt levels which in turn produces lower economic growth due to the burden of debt servicing costs. From 1980 to 2000 real GDP fell to 2.8% (0.5% below the previous century).

click to enlarge

It took nearly 50 years (1950 to 2000) for US Total Credit to reach US$30 trillion. The next US$30 trillion in debt has only taken 13 years (2000 to 2013).

The greater the debt, the greater the burden on the economy. More money (even with lower interest rates) is used to service debt. Less of today and tomorrow’s income becomes available for further credit expansion and consumption. Therefore it is no surprise since 2000, the GDP growth rate has halved from the 1980–2000 rate.

If you think of the debt as a sack full of rocks and the economy as soft sand, then you have a mental picture of the energy expended in dragging this (ever-increasing) weight through the system. The economy is fatiguing under the current debt burden. How much more laden will that sack of rocks become if interest rates rise?

All that extra borrowed money found its way into the economy — as evidenced by the following chart (courtesy of FRED).

click to enlarge

US GDP rose approx. 17-fold over the same period that debt grew 30-fold.

And the winner is…

The new economic paradigm Nixon ushered in on August 15, 1971 faltered in 2008.

The wheels started to fall off the financial industry’s wagon — sub-prime, Bear Stearns, Lehman Brothers, AIG et al. The wobbling financial sector needed an ‘all hands on deck’ rescue plan.

Minsky’s ‘stability leads to instability’ theory is at play in the following chart (courtesy of Phillppon) on the growth of the US Financial Industry.

click to enlarge

As credit expansion became the boom industry, the winner has been the financial sector. The continual need to satisfy increasing risk appetites and demands for higher profits led product developers into a world of complex investment instruments — mortgage backed securities (MBS), collateralised debt obligations (CDO), credit default swaps CDS) etc.

Each derivative product added another deck to the financial industry’s already precarious house of cards. The Fed has managed to prop up the house of cards, but for how long?

Governments needing to sell an enormous amount of bonds (to remain solvent) have been the gift that keeps on giving for the financial industry. Such a cosy arrangement.

For the record, note the previous period of financial industry expansion ended ominously with the Great Depression. Nixon’s legacy is a global economy with a 43-year old addiction to credit growth. The survival of the economic model is only possible if more debt is added to fuel the fires of growth.

But as the GMO chart shows, more debt does not necessarily generate more growth. The tentative positive economic readings we are seeing have resulted from five years of money creation and sustained low rates. In truth the central bankers have paid a very high price for not much at all.


Vern Gowdie+
for The Daily Reckoning Australia

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Vern Gowdie

Vern Gowdie

Vern Gowdie has been involved in financial planning in Australia since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top 5 financial planning firms in Australia. He is a feature contributing editor to The Daily Reckoning and is Founder and Chairman of the Gowdie Family Wealth advisory service and editor of the Gowdie Letter To follow Vern's financial world view more closely you can you can subscribe to The Daily Reckoning for free here.

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3 Comments on "The Real Deal or An Economic Mirage?"

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2 years 6 months ago

There is only one story of significance and that story is QE.

If Australia’s position wasn’t so much more extreme in respect of having being the “beneficiary” of funny money for decades (of which QE is only the most recent incarnation), our leaders comments would mirror those of the Indians more precisely….

What happens when the collective reputation of a presiding oligarchy is trashed? Nothing good unfortunately. Vengeance is no reward.

slewie the pi-rat
slewie the pi-rat
2 years 6 months ago

the accounting changes are driving the economy.
growth is assured, comrades.
next, the accountants are gonna tackle global warming with a carbon accretion delowance which will capitalize a giant planetary refrigeration unit driven by nukes.
trust me.

2 years 6 months ago

It’s all good until its not. Then the greater fools will find out.

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