Analyzing the “causes” of the global imbalance rather than describing the “effects” will help us to better understand where we are.
In the financial world today, the media is saturated with COVID-19 Virus induced market volatility commentaries. You have pundits on screens expounding their wisdom 24/7.
Close to 95% of the essential commentary summarizes to “The market should have been up but there were more sellers than buyers so the market declined 10%.
This virus thing must be bad.
But everything is fine. I am purposely trivializing the observation to make one point. These days one gets the expert badge by describing the “effect”.
We don’t have critical analysis of “causes” anymore. Perhaps a superficial one or two layer description of the event is what people want to hear. The general audience may find any deep dive into the core “causes” boring, complicated and not sexy.
Today, I want to share two simple analyses to illustrate that understanding “causes” may not be boring (fingers crossed) and can give you an insight to how to better understand the problems and events.
Let’s go to the videotape (probably carbon-dating myself with this comment).
What We Have And What We Earn
I will use a hypothetical example to explain this concept. Polar Bear earns $100,000 a year. He has many family members and they eat a lot so he needs to spend $90,000 per year for living expenses.
He has a million dollar home. He borrowed $900,000 to buy it. One question here, if the value of the house drops to $800,000, will the Polar Bear’s family spend more or less?
I think they will spend less.
Well you just completed a quick tutorial on balance sheet and income statement analysis. A balance sheet is what we have and what we owe. An income statement is what we earn and what we spend.
The over simplified example shows how the condition of the balance sheet impacts how we spend. They are linked together and yet today, people don’t want to analyze the balance sheet anymore.
However, at the country, company and household levels, it is precisely the problems on their balance sheet which are holding back demand growth. Yet everyone concludes that the Polar Bear still earns $100,000 so there are no problems.
The global economy’s problem is on its balance sheet. That is the “cause” of the problem. But we usually analyze the “effect” only—in this case growth.
What We Are Calling Growth May Not Be Growth
Let’s use a real economic condition to discuss the previous concept further. When we build office buildings, houses, and factories, we capture this as GDP growth. It makes sense that we invested more to build these things so it should be classified as growth.
However, if those office buildings, houses, and factories declines in value or shuts down, we do not classify that as contraction or negative growth. Why? The problem is in the balance sheet not in the income statement.
Absurd isn’t it? Yet this is the convention.
Folks, this is not a hypothetical example, this situation is everywhere around the world today. It is this unrecognized loss on the balance sheet of the global economy that will be the “cause” of the pending economic crisis. The virus related demand contraction will act as a catalyst to unmask this massive problem on the global economy’s balance sheet.
Feeling Good Today Versus Being Healthy
As the global economy evolved over the past twenty years, one oddity was how the financial markets were nonchalant about the risks in the public and private sectors’ balance sheet.
One reason is the actions of the central banks around the world. They have flooded the financial system with so much money that the price of risk got distorted. If the central banks are making it cheaper to borrow regardless of your ability to pay or your credit profile, the logical thing to do is to borrow as much as you can, and everybody did.
The total global debt stock is estimated to be around $260 trillion. This is about 3-times bigger than the size of the global economy. Debt stock nearly doubled in the past 10 years. This week, major central banks around the world announced close to $3 trillion of new money creation. Financial markets continued to sell-off.
Perhaps the markets are sending a message back to the central banks. What you are doing is trying to make us feel good today but not making us any healthier and that your medicine is not good.
Now that you understand the “cause” of the problem, when experts talk only about the “effect”, you can chime in and say, “what about the bloated global balance sheet?”
Related article: Three Phases of Crisis
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