Data point to end of bumpy road

Last week in this column I wrote about the impending turn in the US labour markets. We concluded with a tentative, but hopeful: "The early, and inconclusive, evidence [of an economic turn around] is positive."

Serendipitously, it seems, the present week brought us the US employment numbers where the Bureau of Labour Statistics (BLS) reported that nearly 243,000 new jobs were created (in contrast to the expected number of 125-150,000). Concurrently, the unemployment figures declined to around 8.3 per cent (from 8.5 per cent in December).

Yet, as the wisdom goes, one rally or employment report maketh not a recovery! Over the past four years: as households began to default, the assets held by banks become worthless, which in turn led to a freeze in the commercial paper markets and threatened to bring down the financial architecture.

Sovereign governments stepped in to bail out banks — and resultantly worsened their own balance sheets. Their debt-to-GDP ratio and credit premiums on bonds spiked. A household credit crisis began to transmogrify into a sovereign debt crises.

The cure to all this, as common sense dictated, was deleveraging: reducing the ratio of borrowings to assets held.

Why should deleveraging matter? Conventional reasons for reducing levels of debt is that the econ-omic agent (a citizen, a bank or a country) would be more likely to avoid defaults on payment, avoid asset appreciations fuelled by easy money and lower the amount of interest payments made (and thus reduce the perceived credit risk).

Fair reasons

These are all fair reasons, if one treats the problem in isolation (as economic models tend to do). In a complex, multi-agent economy there is a deeper reason why deleveraging matters. Debt is the mere transfer of future monies, intended for future consumption, into consumption and investment in the present.

This inter-temporal shift of investment changes the marginal productivity of capital [i.e., how much returns on capital can one get per additional unit invested] which is the real interest rate in an economy. Since investments are made with returns in mind, we are likely to have over and under investment in some sectors. Predictably, so does societal changes and human capital investment veer off course. One tangible result is a surplus of credit derivatives theorists but not enough civil engineers or Arabists!

Debt, in this sense, causes wildly distorted investments across the economy and society. Deleveraging is an effort to reprice the cost of inter-temporal consumption, to re-prioritise investments into appropriate sectors of the economy while respecting present technological and economic constraints.

Of all industrialised countries, since 2008-09, there are only three countries who have reduced their debt to GDP: Australia, South Korea and US.

Study

In a recent study McKinsey reports that the financial sector's debt to GDP contributions have fallen back to levels in the early 2000s.

By 2013, the US households are expected to arrive at their pre-2003 levels of debt to disposable income. Most develeraging cycles usually have a phase when the private sector debt reduces [and economic growth hits a low]; followed by a rise in government debt.

In the second phase, private sector slowly begins to expand and growth begins; and governments initialise plans to reduce their debt.

The US is evidently a classic example of this cycle. What we don't know, however, is the impact of this cycle on the economic geography. Will some cities be permanently damaged, will coastal areas boom, will some industries leave the US for ever, will industrial policy measures bring them back, etc.

In aggregate, the news is positive (even if painful to many as dislocation manifests). As tempting as it is to see equity rallies and pat oneself over the back; the dark road to recovery is still hard and full of uncertainties. It seems, for now however, a light is visible at the end.

The columnist works for a major European investment bank in New York City. All opinions are personal and don't reflect any institutional perspectives.