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The only way to fix the economy might be for the stock market to 'collapse'

building demolition
building demolition

(China Daily/Reuters)

The US economy and financial system is a mess of contradictions right now.

Bond yields are hitting record lows while the stock market is hitting record highs. The labor market is signaling full employment, but GDP growth remains lackluster.

According to the fixed-income research team at Deutsche Bank, there is a way for these conundrums to work themselves out, but it will take some pain for us to get there.

Specifically, stock market-crash pain.

Essentially, Deutsche's fixed-income research team argues that many of the issues facing the financial system come from central banks using interest-rate cuts, asset purchases, and other monetary-policy measures to spur economic growth.

The team thinks that this has reached its limits and that we have entered a period of "financial repression," in which rates are kept low and economic growth is limited.

In order to deal with this, the Deutsche team said that more aggressive fiscal policy, including serious government spending to build infrastructure, hire people, and grow the economy, is needed.

Now this isn't a new idea. Everyone from hedge fund titans to both leading presidential candidates have mentioned the need for government investment to kick-start economic growth. The issue almost everyone has cited is legislative pushback and attitudes toward taking on more debt.

The Deutsche team agreed that stimulus is unlikely given the political landscape.

"It is still too early to call the US election and stimulus prospects here but the general sense is that it is still difficult to sense the urgency when equities make new highs," said the note. "Policymakers aren't used to dealing with financial repression and that unfortunately is one of the defining characteristics of stagnation."

The only way to get the political will to grab on to this solution, in the opinion of the Deutsche Bank team, is for something drastic to happen: a stock market sell-off. Here's the Deutsche team (emphasis added):

"The conclusion is that without an external economic shock it is hard to see policymakers being prepared to take dramatic, fiscal action to jumpstart the global economy and bounce it out of a financial repression defined by low and falling real yields to one that at least initially is defined by rising nominal yields through higher inflation expectations. Ironically the shock that is needed would require a collapse in risk assets for policymakers to then really panic and attempt dramatic fiscal stimulus."

The idea here is that some short-term pain in the term of a stock market drop or crash would look bad, but it would inspire movement from policymakers to do the one thing that could seriously sustain the economy over the long term.

It may not be a pretty sight for investors, but it the move could anchor inflation expectations and drive real economic growth, thus untangling the financial contradictions in the system and break the "repression."

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