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The Bond Column

What Ails the Global Economy?
Updated: 2016-06-20, 08:55:52 ET
Analyst: David Kelland

The German 10-year Bund yield touched 0.00% on Friday and theU.S. 10-year Treasury yield fell to 1.64%. The West is starting to look moreand more like Japan, with the University of Michigan's long-term inflationexpectations falling to 2.3% in June, its lowest since records began in 1979.U.S. stocks sport high valuations but much of that premium may be based onlow interest rates and low volatility. What is wrong with the global economy?

Shortly after theglobal financial crisis, I came across the balance sheet recession theory proposedby Richard Koo, the chief economist at the Nomura Research Institute. Theconcept is that when firms have borrowed money to buy assets that havesubsequently depreciated sharply, they become technically insolvent. That leadsthem to pursue debt reduction rather than profit maximization as a guidingprinciple. The theory's greatest strength is that it helps to explain theimpotence of monetary policy in the face of the Great Depression, Japan's Lost Decade(s), and the aftermath of the Great Recession. If firms are trying to minimize debt rather thanmaximize profit, then access to very cheap money would not entice them toborrow more. The balance sheet recession concept could also explain how theworld exited the Great Depression via military spending for World War II.

There is alsoevidence of a lack of demand for loans during the Great Depression. The FederalReserve has taken much criticism - some of it from none other than former FedChair Ben Bernanke - for raising interest rates in the early 1930s. What those early central bankers saw, however, was a buildup of excess reserves in the bankingsystem that could unleash high inflation if it was ever borrowed.

Andrew Smithersof Smithers & Co. says we are not in a balance sheet recession. In his 2013book, The Road to Recovery, he blames equity-based executive compensation forlow levels of corporate investment. According to Smithers, if the balance sheetrecession were really the problem, why would corporations in Anglo Saxoncountries be aggressively buying back stock? Stock buybacks do not repair one'sbalance sheet. The buybacks do make sense, however, if executives are loathe tomake risky investments with long time horizons rather than produce incrementalgains by cutting costs. That behavior does make sense in light of the proliferation of equity-based compensationpackages. Those pay packages encourage conservative strategies like pursuing incrementalrevenue growth through price increases and cost cuts through offshoring, rather than risky strategies for aggressive growth.

A thirdpossibility is simply that there are no good investment opportunities to pursue- the secular stagnation theory proposed most famously by Robert Gordon in his2016 book, The Rise and Fall of American Growth. This is a theory that has beenpopular in the news and the blogosphere lately, but could just be a reflectionof negative sentiment.
In any case, thefirst two books are good reads and I anticipate that the third one will be aswell.

- David Kelland,