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Opinion

Against the tide: The stock and flow of economic recovery

The authorities have run out of ways to deal with the debt overhang and to create new credit. The only palatable way out looks to be a period of generalized inflation

The rate of global economic decline has peaked but the world economy is still contracting. Deleveraging has a long way to go and the debt overhang will restrict the pace of any subsequent economic recovery.

The core problem remains the overwhelming burden of debt throughout the financial system and the continuing incapacity of borrowers to service it. This concept of stock and flow is central to how investors need to think about recovery. The authorities have done much to ease the short-term flow issues (debt service, etc) by borrowing from future generations to bail out today’s. This has prevented systemic implosion and explains why equity markets are off their lows.

But this has failed to address, and in many ways has compounded, the stock (of debt) issue. Large debts per se need not be problematic. Many of us live in homes we cannot afford to buy outright. As long as the value of our houses exceeds the value of our mortgages, and as long as we can comfortably service that borrowing, we manage perfectly well.

For an individual family, difficulties arise only if mortgage interest rates move appreciably higher (depleting discretionary income), the breadwinner loses his/her job (wiping out income entirely), or if the market value of the house drops materially below the book value of the mortgage.

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