Don’t worry about deleveraging… | FT Alphaville

Don’t worry about deleveraging…

… says Goldman Sachs.

The rather dramatic drop in US consumer credit outstanding has sparked yet another recovery debate, with many claiming the global economy will be unable to get back on its feet without consumers going back to their old, spend thrift ways.

Goldman analysts led by Jim O’Neill present an alternate view in a research note out on Thursday. They say the deleveraging cycle is happening but it won’t imperil long-term economic recovery. That’s not to say, however, that the guys at GS don’t think deleveraging will have any impact.

Indeed they think it could shave a couple of points off US GDP:

These are very rough `back of the envelope’ estimates. However, taken at face value, they suggest that holding everything else constant, deleveraging could shave about 1-2ppt off growth over the next three years as the US financial system recovers from the crisis, and about 0.5- 1ppt thereafter, as consumption as a share of GDP declines towards its historical average.

The point, however, is that there will be other things to offset that deleveraging:

While the calculations above are subject to much uncertainty, they do suggest that the deleveraging cycle will have a noticeable drag on growth in the coming years. This has led some commentators to suggest that the US is on the brink of a `Great Stagnation’, a period of prolonged subpar growth and high unemployment.

Our view is more optimistic . . . we see a number of tangible offsets to the deleveraging cycle over both the near term (when deleveraging will pose the greatest drag on growth) and the medium term. In the near term, continued fiscal stimulus and a slowing in the pace of inventory liquidation should help boost growth to about 3% in 2009H2 in the US, and possibly even higher.

However, the risk of a double-dip recession will likely surface once these short-term catalysts begin to fade by the middle of next year, with fiscal spending in particular likely to become a drag on growth over the course of 2010. At this stage, the economic recovery will become increasingly dependent on two factors: (1) the recovery in investment spending, and (2) the tailwind provided by buoyant growth in emerging markets.

And how does one boost investment spending and stimulate growth in consumption? Lower interest rates, of course.

And according to Goldman, if one thinks, as they do, that deleveraging will generate a minimum one percentage point of drag on GDP growth between 2011 and 2015, US interest rates would need to be about two or three points lower than they would normally be during a `typical’ post-recession recovery.

However, there’s a problem:

With the Fed and other central banks often accused of being `serial bubble blowers’, one cannot discount the possibility that we will see premature tightening. Indeed, a number of prominent observers have argued that keeping interest rates `artificially low’ will only postpone the day of reckoning. As the argument goes, it is better to take the bitter medicine now and purge the financial system of excess leverage so that a sustainable recovery can ensue.

Yet, the experience of the Great Depression casts doubt on this view. Between 1921 and 1933, the ratio of private debt to GDP increased from 144% to 227%. On the surface, this suggests that the Depression was payback for the huge credit boom that preceded it. And there are elements of truth to that — margin debt did get out of control in the late 1920s and was a key driver of the stock market boom that ended with the Great Crash in October 1929. But here is the rub: at the end of 1929 – a few months after the crash — private debt was only 156% of GDP. In other words, about 85% of the increase in the private debt to GDP ratio occurred in the four years after the crash.

How could this have happened? It wasn’t because the stock of private credit increased — it actually decreased by 21% between 1929 and 1933. Rather, the debt to GDP ratio swelled because GDP collapsed, with nominal GDP declining by 45% over this period. The lesson here is clear: if you want to bring down leverage, you should keep monetary policy sufficiently accommodative (and if the zero nominal interest rate floor is binding, use nontraditional easing and fiscal policy as necessary) to forestall a collapse in spending and a deflationary spiral.

Goldman Sachs says more “ease please.”

Will the Fed listen?

Related links:
US consumers, massive deleveraging in full swing – FT Alphaville
The shape of things to come will probably not be a `V’ – FT Alphaville
The deleveraging process is inevitable – FT Economists’ Forum