For investors under about two-score years of age, these are confusing times indeed. It used to be pretty easy to tell when the world was booming. And when things turned bad, at least the contractions were easy to spot too. Today, however, global economic data are surprisingly strong one month – for example, the raft of manufacturing numbers released yesterday for July – and weak the next. Single indicators are often not conclusive in any direction.
Hypotheses for the incongruities abound. It certainly does not help that monetary and fiscal policy regimes are off the charts and that half the world is seeing explosive growth at the same time as the other half lies sick on its back. What is more, data are always volatile around turning points. But in order to make money, investors need something more solid to grab on to. Returning to first principles is always a good place to start.
It is clear that developed country budget deficits are too large. As a percentage of aggregate 2010 output, for example, G5 deficits are approaching 10 per cent. It is also obvious that western governments are keen to reduce them. Trouble is, for deficits to fall, private sector cash flows must also fall by the same amount because, mathematically, the sum of all sector cash flows must equal zero. That means either businesses or households have to take the hit, either on their own or helped by current account surpluses.