In part one of our two-part series on macroeconomics we detailed why incorporating macroeconomics into your investment process is critical. A proper understanding of the macroeconomic environment can help you make better decisions when it comes to identifying attractive countries in which to invest and help you better project a company’s future earnings. But understanding the macroeconomic environment can be difficult.
Just like with stock analysis the macroeconomic world is filled with people constantly offering their opinions. On top of that we are bombarded with a litany of economic statistics. Fed manufacturing surveys, jobless claims, PMI surveys, consumer confidence, freight car loadings, the Baltic Dry Index and on and on. So how can we make sense of it all?
Well, think of things the same way you do value investing. This site is called GuruFocus because it focuses on a group of highly successful value investors and the methodologies they use. The basic formula is a simple focus on buying good companies at attractive prices. We can do something similar and focus on two of the most important but misunderstood economic concepts: private sector debt and public sector debt. By understanding these two concepts properly we can make better macroeconomic predictions, and that translates into an important advantage when investing.
Understanding private sector debt
Perhaps one of the most misunderstood aspects of macroeconomics is the role of private sector debt. Almost all of academia uses what’s called the “loanable funds” model of the banking system. This model posits that private sector debt does not matter because deposits fund loans. In the model all bank loans are offset by corresponding deposits –Â a bank can only make a loan if it has a corresponding deposit. In this model banks simply function as financial intermediaries moving funds from savers to borrowers. The net amount of money in the economy does not change under this model.
Despite its widespread use the model is demonstrably false. Just go down to your local bank and take out a loan and ask the bank manager if the bank needs to find a corresponding deposit somewhere in the banking system before it will loan you money.
But you don’t even need to do that. The most recent organization to tell everyone in no uncertain terms that the banking system does not function this way was the Bank of England in this recent paper.
The paper says, “The currently dominant intermediation of loanable funds (ILF) model views banks as barter institutions that intermediate deposits of pre-existing real loanable funds between depositors and borrowers. The problem with this view is that, in the real world, there are no pre-existing loanable funds, and ILF-type institutions do not exist.”
Don’t believe the Bank of England? Well the International Monetary Fund said the same thing in this 2014 paper, and the Federal Reserve also released a paper back in 2010 disproving part of the loanable funds model.
Given how widely and thoroughly debunked the loanable funds model has been it’s exceedingly odd that it is still taught in macroeconomic textbooks and widely used by many economic forecasters. Old theories die hard, I guess. So how do the banking sector and private sector debt really work?
Well, as those three papers describe, loans actually create deposits. That is, if you walk into a bank and ask for a loan and the bank deems you a good credit risk it will extend you a loan that creates a corresponding deposit. Say you’re getting a mortgage for a house and get a loan for $200,000. You owe the bank $200,000 and the bank creates a corresponding $200,000 deposit in your account. You now have $200,000 that you didn’t before and those newly created funds are then put into the economy (in this case to buy a house).
In the short term growing private sector debt is expansionary. As more loans are created more funds enter the economy. The housing bubble leading up to the Great Recession is a great example of this; the economy was growing at full steam. Over the long term growing private sector debt is detrimental to an economy because the loaned funds need to be paid back. Just as taking out a $200,000 loan adds $200,000 to the economy, paying back that same loan removes those funds plus more in the form of interest from the economy.
Investors should carefully monitor private sector debt levels in the economy. The debt-to-income ratio of the household sector is especially important given that consumer spending makes up around 70% of the U.S. economy. Rising consumer debt levels are bullish in the short term, but if private debt begins to rise above historical norms it usually signals a sharp drop in economic activity once the debt-fueled expansion ends.
We can see how household debt growth fueled the economic expansion of the '90s and early 2000s and how a collapse in the growth of household debt led to a collapse of economic growth in 2008.
Given how widespread the loanable funds model is among academics, policymakers and investors, understanding how private sector debt actually works can give you an important advantage when examining the macroeconomic picture.
Now on to government deficits and debt.
Understanding government debt
Japan has a government debt-to-GDP ratio of over 300% and yet it actually pays negative interest on many of its government bonds. For decades people have been predicting that the Japanese debt “bubble” will collapse and interest rates will skyrocket and yet nothing has happened. Greece’s debt-to-GDP ratio peaked at around 150% and 10-year bond yields reached almost 30% prior to the country needing a bailout. So what gives? Why has nothing happened in Japan while Greece went “bankrupt”?
My grandma owns U.S. Treasury bonds. Many politicians and economists assert that paying down the national debt and reducing the deficit will be great for the economy. Why would taking away Grandma’s Treasury bonds and making an 85-year-old poorer be good for the economy?
Many people prefer to analyze governments the same way you would a household or corporation. They think that when governments spend more than they take in taxes they need to access the bond markets to make up the difference –Â the same way a household might rack up a credit card bill to buy a new refrigerator or the same way a corporation might tap the corporate bond market to fund the buyout of a smaller rival company. Differences between countries' borrowing rates and why some countries need bailouts and others don’t are always explained away with some hand waving about the vagaries of populations' savings rates, safe haven demand, central bank policy, trade balances and anything else that sounds suitable. The problem is this isn’t remotely how things work. Countries are not households or corporations, and things are different for some.
Countries fall into one of two categories. Either they have government debt that they issue that is in their own currency or they have debt that is denominated in a currency they don’t control (this includes any country that uses a fixed exchange rate). Countries that have debt solely in a currency they control are never under threat of bankruptcy. Conversely, countries that have debt in a currency they do not control, like Greece, can go bankrupt. Just like a household or corporation these countries are borrowing currency they do not have.
For countries that have debt in a currency they control the national debt is not so much a debt at all. It is basically the accounting identity that results from supplying enough financial assets to the economy to satisfy the savings desire of the private sector. Think about it this way. The national debt is nothing more than the sum of all Treasury bonds outstanding. The chart below shows the relationship between private sector savings (this includes both domestic and foreign sectors).
As you can see the government deficit is exactly equal to the private sector savings rate plus the trade deficit. Since the government controls the currency and is the sole issuer how can it borrow? You can’t borrow something only you can create. Every net dollar in existence is one the government created. Instead the government basically creates new currency and then issues Treasury bonds in the exact amount because it is legally obligated to do so by Congress but also to maintain interest rates and the proper amount of reserves in the banking system.
The role of the government sector deficit is to provide enough financial assets for the economy to function at full capacity. Think of it like a thermostat. When the economy is cold like in 2009 massive government deficits (or more technically spending either via direct spending or tax cuts) are needed to stimulate it. More money needs to be added to the economy to stimulate demand. When the economy starts to overheat and we are at full employment, full industrial capacity utilization, and suffering from high inflation, then reductions in spending are needed to cool the economy.
Just take a look at what’s happened with economies since the Great Recession. In response to the recession most governments introduced some form of fiscal stimulus with the U.S., U.K. and China introducing some of the largest spending packages. It’s no surprise that those economies have seen the best recoveries. In 2010 and 2011 the U.K. tried implementing austerity and the U.K. economic growth went negative and almost entered a recession. The U.S. experimented with “austerity lite,” too, cutting the deficit via the budget sequestration agreement, and the economic recovery began to peter out. Look no further than Europe for the greatest failure in government fiscal policy. The EU has forced austerity onto many of the periphery countries and forced Greece into a deep depression and caused huge recessions in Italy and Spain among others.
Understanding how deficits and government debt really works can make a huge difference when forecasting the direction of an economy. Investors should understand that the EU nations do not control their own currency and are largely powerless to implement any fiscal stimulus. As long as Germany, the EC and ECB keep insisting on austerity the economies of the EU will never make significant recoveries. Investors will understand that there is no risk of a debt apocalypse in Japan and that Prime Minister Abe’s rumored new fiscal stimulus measures could be bullish for the economy. Understanding the macro picture can help investors indentify the best areas to hunt for individual stocks.
Summary
While these two macroeconomic items aren’t the only thing to keep an eye on they certainly are two of the most useful. And even more important than that they are two of the most misunderstood. Investors who really understand how debt functions in an economy can often take advantages of other’s ignorance and scoop up stock market bargains. Understanding these macroeconomic concepts will also help you not to panic during regular market downturns by understanding what is the biggest driver of the direction of an economy.
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