By virtue of more than a decade of low and often negative real interest rates coupled with increasingly rapid monetary growth, the economies of the developed world have been increasingly skewed towards consumption rather than production. Unfortunately, consumption is the destruction of capital – by definition it represents the diversion of resources from productive purposes. Both the private and public sectors have been indulging in this protracted debt fuelled consumption spree. Savings rates have plunged and fiscal deficits have expanded. Each year it requires a larger and larger amount of additional debt to create each additional unit of GDP – on the order of $4 of incremental debt to $1 of incremental GDP. Why? Because on average, we are incurring debts that do not create offsetting cash generating assets. At some point this trend must result in default – whether outright or via the printing press.
Surprisingly or perhaps not surprisingly, the governments of the world seem intent on continuing this trend as they desperately force feed the markets consumption-oriented programs in place of stagnant private sector demand. An interesting fact is that for the last decade in the US, private sector job growth has been absent and all net job growth has been in government or state dependent sectors. We are facing massive “political inflation” as well as monetary inflation.
The problem arises that all state spending requires that capital is first taken out of the hands of the private sector via taxes, borrowing or inflation, then deployed in typically loss-making (capital destroying) activities. The net result is that the growing government spending and deficits are setting the stage for much greater problems in the future. Rather than allowing private sector savings to replenish the pool of capital our governments are going further into debt to finance policies that at best can only serve to pull future consumption into the present – once again more consumption is not what the west requires at this moment.
So what of the ongoing rally in the equity markets. Rather than indicating a recovery in the western economies, what we have been witnesses is a re-ignition of bank intermediated speculative finance funded by a massive wealth transfer from savers to the financial sector.
To reiterate, what western economies need is more capital. There is no way to create capital other than through savings and hard work – a message to which our governments are reluctant to listen. Printing money seems alluringly easy at first, but it does not create capital, and worse, the inflation it creates ultimately causes long lasting harm to the production structure of the economy. It follows that until the developed nations stop engaging in capital destroying activities and our capital base recovers, sustained real growth is unlikely to take place. A depleted and declining capital pool, combined with enormous expansion of the monetary base and negative real interest rate is creating a high probability of an extended period of stagflation in the west.