Growing down under a debt ceiling

Growth is going to be hard to come by in many parts of the world in future years. Both the Democrat and the Republican 'solutions' to the US debt crisis, if actually implemented, risk a US recession and certainly a slowdown after the 2012 election. The European 'solution' will have a similar outcome and here in Australia, the Reserve Bank is warning anyone who will listen not to expect a repeat of double-digit growth in banking profits. Retailers have the same message.

China becomes the hope of world growth but as if to warn us that without growth among its trading partners the China growth path will not be easy, the Shanghai index fell almost 3 per cent yesterday, because a high-speed train crash threw into jeopardy its highly-leveraged real estate play based on the growth of high-speed trains.

Like everyone else, I can't conceive that the US political system would plunge itself into a position where it could not pay salaries and debts. Yet, if the unthinkable happens and there is no solution to the debt crisis, clearly we are looking at a big fall in global sharemarkets and last night you could smell the apprehension on Wall Street. Conversely if, as is likely, there is a solution, then markets will bounce strongly.

But the 'solution' to the debt problem, whether it be Democratic or Republican, is not a happy event for sharemarkets looking for world growth.

To plot the future under either solution, I have been helped by veteran US economist Al Wojnilower who points out that during business expansions, private credit and debt always increase. As some firms and individuals pay off maturing debts, larger amounts of new debt are incurred by others – that's how the US has run for generations. But where is this extra debt going to come from? In the private sector, growth in self-amortising home mortgages used to be the most sizable and efficient way to accomplish US debt growth, but the malfeasance of financial institutions in polluting the market with subprime mortgages has closed this avenue for the foreseeable future.

The next-best (but much smaller) channel has been consumer instalment borrowing to buy automobiles, but this channel is once again constricted, mainly because of the higher oil prices. Business inventory accumulation is another source of self-sustaining credit growth, but such accumulation now seems near its peak relative to sales, orders and backlogs. The sad outcome is that credit growth to consumers and businesses remains moribund, as is confirmed by the just-published data for the first quarter of 2011.

Nevertheless, US GDP has been expanding – but only because Treasury borrowing and spending has been filling in the gap in private activity. If Treasury borrowing were to diminish as a result of the 'solution' without a compensating increase in private debt, the US GDP would fall.

So the proposed Republican and Democrat 'solutions' each risk a US recession and certainly low growth. It's now the way of large parts of the world.