The debt keeping us down

So why is the Great Recession so much worse than a run-of-the-mill business-cycle recession? (It is so much worse that Rogoff and Reinhart say the term Great Recession is misleading; they prefer Great Contraction, a category that for them includes the Great Depression.)

Because, Rogoff, Reinhart and other economists argue, the financial crisis left the global economy with a huge amount of debt on its balance sheet. For consumers, that debt has meant a desire to save rather than spend. For healthy companies, it has meant a hesitancy to borrow in order to grow. For debt-burdened companies, it has meant cutting back on spending and shrinking operations (and workforces) to pay off debt. For national (and local) governments, it has meant using taxpayer money to bail out banks and manufacturing companies just as falling tax revenue puts pressure on government spending. The U.S. unemployment picture, for example, would look much brighter if state and local governments hadn't had to cut teachers, firefighters, police officers and park workers in order to make their budgets work.

In other words, before government and business and consumers can get down to the business of increasing demand, the global economy has to do a massive amount of deleveraging.

How much deleveraging, and how long might it take? When you start looking at public and private debt together, the picture is even darker than the discussion of the insupportable level of government debt in Spain or the United States indicates. A study by McKinsey Global Institute in 2010 calculated that combined public and private debt was near historic highs in many of the world's developed economies. Combined public and private debt then stood at 500% of GDP in the United Kingdom, McKinsey concluded. In Spain, the combined debt level was 375%. In the United States, it was 290%, and in Germany, 280%. Reducing these burdens by even 25% McKinsey figured in 2010, would take an average of six to seven years.

McKinsey updated that study this year, and the results are depressing. Despite all the pain, in only one developed economy -- that of the United States -- has the debt burden fallen significantly. In other economies, it has stopped climbing, but the deleveraging has only begun. Private debt is the source of much of the drop in the debt burden in the United States, with households reducing their debt to 112% of annual disposable income, down from a peak of 127% in 2007. Of course, the picture on the public side of the debt balance sheet isn't nearly as encouraging, with the United States badly lagging countries (such as the United Kingdom) that have drastically cut public spending while raising taxes.

The devil in the deleveraging

How do you deleverage? Well, if you're a consumer, your choices are rather limited. You can save more and spend less. And you can reduce your debt by defaulting on some of it. That's pretty much the menu for corporate borrowers, too.

Governments have those three options -- save more, spend less and default (although default by a government is a much more drastic step than a consumer or corporate bankruptcy and reorganization) -- plus a couple that aren't open to consumers or corporations.

Governments, through their control of monetary policy, can inflate their way out of debt. Higher rates of inflation have the effect of reducing the real value of existing debt. And governments can, at the same time as they encourage inflation, work to repress the interest rates they pay on their debt by pursuing, just to take an example, a policy of low interest rates and massive buying of government debt through a program of quantitative easing.

Recognize many of these -- and in particular the last two -- for exactly what they are: a massive reduction in the burden that debtors carry at the expense of creditors.

In some fantasy world, governments -- as well as consumer and corporate debtors -- would oppose the reduction in their debt burden at the expense of the creditors who lent them the money they used to buy houses or develop new sources of natural gas or to fund the rising costs of health care.

But in the real world? Not a chance. The crisis has been too big; the hole that debtors find themselves in is too deep. Debtors will pursue every method available to them to make the global deleveraging as quick and as painless as possible. And even when all these methods are pressed into use, the deleveraging will be neither particularly quick nor especially painless.

Growth can't beat this debt

What about growth? Is it possible for the world to grow itself out of this debt hole? That's surely an attractive alternative -- the debt burden would fall as a proportion of GDP as the size of economies increased. That growth would add to tax revenue, without raising tax rates, and the added revenue could be used to reduce the actual size of the debt burden.

Unfortunately, the global economy, now and for years to come, doesn't look especially hospitable to growth -- thanks in large part to the aftereffects of the credit boom that preceded the 2007 credit bust and to stimulus packages unleashed in 2008 to stabilize the global economy.

The worry is that the world didn't have enough good investment opportunities to absorb all that capital. The money did go into roads and airports and the purchase of more efficient equipment, but it also went into an overpriced high-speed rail network in China, half-empty commercial and residential projects throughout Asia and a global expansion of capacity in the solar, steel and semiconductor sectors. It isn't that investments in those areas weren't (or won't be) profitable, but that rate of return on recent investments is less than it was when globalization and the rise of emerging economies were younger trends. For example, Citigroup calculates that between 2002 and 2008, it took four units of investment to produce an additional unit of Chinese GDP. Between 2009 and 2011, that ratio rose to five units of investment to produce an additional unit of GDP.

That doesn't mean that China or any other emerging economy has stopped or will stop growing. But it does argue that it will become more difficult and expensive to increase growth rates in order to grow out of the global debt burden.

And it means that anyone thinking that China or any other emerging economy will "bail out" the world with a repeat of the huge post-Lehman stimulus package is likely to be disappointed.

In this situation, investors should watch the debt loads that are accumulating in the developing economies. If growth in this part of the global economy is to be more modest than in the past, investors can't simply say debt -- public and private -- in these economies doesn't matter because these economies will be able to grow their way out of any debt problems. The debt service costs for households and companies in Brazil, China, Turkey and India have marched upward recently. In China, for example, private sector credit has risen from 107% of GDP in 2007 to 127% in 2011, according to Capital Economics. In Brazil, consumer credit is a lower 50% of GDP, but because the average interest rate on consumer loans was a staggering 35.3% in April (down from 37.3% in March), economists have started to worry that the Brazilian consumer is overstretched.

So where does all this leave investors?

  1. Back on May 14, I advised that, in the short term, you shouldn't bet against the world's central banks in "Can the central banks keep us safe?" I think that advice needs an update. We are already nearing a point where decisions at the Federal Reserve, the European Central Bank and others are having less and less of an impact on economic growth in the short and medium term.
  2. But in the longer term, a version of that advice still holds: Because their conventional tools are providing less and less bang for the buck (or euro or yen), I think central banks will gradually move toward unconventional methods such as allowing inflation to rise while continuing to suppress bond yields to the degree they can. (Suppressing bond yields also has the effect of supporting stock prices.) If this scenario is correct, it is one more reason to prefer dividend stocks, with their (one hopes) rising dividends to the fixed payouts of bonds.
  3. I do not see a way out of the current Great Recession (or Great Contraction, if you will) without substantial inflation. I think investors can expect rising inflation (and rising inflation targets at most of the world's central banks) over the next decade. Hard assets -- to the degree that their prices aren't depressed by slower economic growth -- will do well in that environment as a defensive haven. That's especially likely to be the case as the U.S. dollar loses some of its allure as a safe haven, not because of problems with other currencies, but because of rising U.S. inflation.
  4. My favorite hard-asset stocks would be in the gold and oil sectors.
  5. There will continue to be economic growth in the world, but it will not be so strong across the board as to constitute a rising tide that will lift all stocks. I'd expect that for returns, stock selection inside individual markets will become relatively more important than the selection of individual markets.
  6. In a world of slower growth and increasing pressure on rates of return on invested capital, I can think of two classes of investment opportunities to watch for. First, look for the companies facing the most opportunities for high returns on future investments of capital. I gave you advice on using rate of return on invested capital to do that, and the names of some stocks to watch, in my June 14 column, "Investors, eat more Big Macs."

    Second, look for companies that are successfully pursuing their own deleveraging strategies. Shares of highly indebted companies that are relatively quickly digging themselves out of their own debt holes should move up even if global economic growth is sluggish.

If all this sounds to you like a very difficult investing environment, then you're hearing my message loud and clear. Add in the volatility that I expect and that I've described in my columns on the paranormal economy (see "5 rules for an X-Files market" to get started on that topic), and the challenge gets a bit more daunting.

But we like challenges, don't we?

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Jim Jubak's column has run on MSN Money since 1997. He is the author of the book "The Jubak Picks," based on his market-beating Jubak's Picks portfolio; the writer of the Jubak's Picks blog; and the senior markets editor at Get a free 60-day trial subscription to JAM, his premium investment letter, by using this code: MSN60 when you register at the Jubak Asset Management website.

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