Crowding Out

"Blessed are the young, for they shall inherit the national debt." - Herbert Hoover

In economics the term crowding out refers to an economic state where government involvement in an economy becomes so great that the private sector is “crowded out” of the market.  As there are only so many goods and services available to be made or purchased increased government involvement can have the impact of taking the market away from individuals and companies.  The same happens in the world of debt.   By printing trillions of dollars a year the government is flooding the market and crowding out private debt.  This was a necessary requirement at the beginning of the great recession (as some have come to term it) as the government needed to use its powerful intervention tools to offset what could have been the worst financial crisis of all time.  However with the follow on quantitative easing rounds that followed the Federal Reserve began to crowd out the normal market.

Now with the deficit at virtually 100 percent of annual GDP studies are pointing to this crowding out effect taking one full percentage point off US growth in the future.  As most economists expect the US economy to grow at a rate of around 2.5 percent this year, shaving 1.0 percent off this growth rate is enormous and could take the US into another recession.  Is that possible so soon after the last one ended?  More research points to the fact that once these levels of debt are reached that recoveries are muted and recessions become more common place.  Hence the likelihood that there is a US and possibly a global recession in 2012 as countries around the world struggle to contain their spiraling debt levels.

I had an investor the other day mention that high levels of debt have been around since the 60’s so why are they such a problem now?  The bull theory goes that it is just a matter of time and all of this will pass and we will be back to business as usual.  The problem is that until recently the debt level in the US was at a manageable level.  In 2007, before the most recent recession began, the US debt to GDP ratio was at around 70 percent.  With the unprecedented increase in the level of debt from helicopter Ben, this ratio has moved to around 100 percent in just over three years.  This sudden explosive rate of growth of the government debt has brought all of the dismal metrics with it and for these reasons I have a negative outlook on the economy.

Sluggish economic growth in Europe, Japan and the US will feed into China and other emerging world economies.  These anemic growth rates are a direct result of the massive amounts of capital and energy required to deal with this problem.  So how do we deal with the problem so that I can get back to buying stocks?  The only way to do this is to reduce the debt level as a percentage of GDP by either growing GDP or paying off the debt or some form of both.

Let’s look at the first part of the equation, growing GDP.  Either industry or the government needs to expand and create jobs which will result in an increase in output.  However, as the numbers above suggest with GDP growth at 1.5 percent and a budget deficit of $1.5 trillion expected over the next few years, the debt level will actually expand by more than 10 percent in the next two years!  So let’s go to the other side of the equation, reducing the debt level.  The only way to do this is to cut government spending but at present there is little incentive on Capitol Hill to cut any of the government programs as this would lead directly to a recession, so I expect that this is off the table for the next few years.

The final way would be to create inflation and inflate our way out of the problem.  The quickest way to do this is to let the dollar depreciate.  The problem with this is that the dollar continues to move higher as the Euro problems are “benefitting” the dollar.  Better to invest in the US than in Europe at present.  Outside of that inflation normally is created when demand for goods and services exceeds supply.  With massive capacity in both employment and global factories and with slow to anemic global growth projected it does not seem that this is a near term probability.  All in all it looks as if for the next twelve months at least that the stock market provides a lot of risk for limited reward.

That is not to say that there are not good stocks out there.  I am certainly not bashing all stocks I just believe in skewing the risk reward equation into my favor before going all in. So right now (in my opinion) prudence is required and investing in the stock market is not a good place in which to place your hard earned investment dollars.