Yves here. Note I beg to differ with Das in his comments on government debt levels for countries that control their own currency. As we’ve noted, a country can always repay debts in its own currency, and the funding of federal deficits by borrowing is a political constraint and a holdover from the gold standard era. Moreover, there is a great deal of evidence that the solution implicit in that view, of cutting government spending in the aftermath of a demand-depressing, private balance sheet wrecking global financial crisis only makes matters worse. This is a case where you need to steer into the skid to get the car back on course. But this section is not core to Das’s discussion.
By Satyajit Das, the author of Extreme Money: The Masters of the Universe and the Cult of Risk
Powered flight requires air to flow smoothly over the wing at a certain speed. Erratic or slow air flow can cause a plane to stall. Most modern aircraft are fitted with a “stick shaker” – a mechanical device that rapidly and noisily vibrates the control yoke or “stick” of an aircraft to warn the pilot of an imminent stall.
The global economy too needs air flow -smooth, steady and strong growth. Unfortunately, the global economy’s stick shaker is vibrating violently.
The GFC Was Never Really Over…
The proximate cause of recent volatility is the down grading of the credit rating US (irrelevant) and the continuation of Europe’s debt problems (relevant). The deeper cause is the realisation that future growth will be low and the lack of policy options.
In 2008, panicked governments and central banks injected massive amounts of money into the economy, in the form of government spending, tax concessions, ultra low interest rates and “non-conventional” monetary strategies – code for printing money. The actions did stave off the Great Depression 2.0 temporarily, converting it into a deep recession –the US economy shrank by 8.9% in 2008.
As individuals and companies reduced debt as banks cut off the supply of credit, governments increased their borrowing propping up demand to keep the game going for a little longer. The actions bought time. But policy makers did not use the time to prepare the global economy for an orderly reduction of debt. There was little attempt to address structural problems, such as persistent trade imbalances between China and the US or within Europe or the role of the US dollar as the global reserve currency.
Governments gambled on a return to growth, solving all the problems. That bet has failed.
Greece was always going to be Patient Zero in the global sovereign crisis, highlighting deep-seated problems in public finances of developed nations. While the deep economic contraction was a factor, government financial problems were structural. Much of the build-up in government debt had taken place before the crisis as a result of spending financed by increased borrowing.
Like individuals and companies, governments did not always use borrowed money for productive purposes, fuelling consumption and making poor investments. Realising that many European governments had too much debt that couldn’t be repaid, investors pushed up the cost of borrowing and then cut of access to funding.
Instead of treating the situation as a solvency problem and reducing the debt to sustainable levels, stronger countries within the European Union banded together to lend the distressed countries the money they needed. Within a period of about 12 months, Greece, Ireland and Portugal needed bailouts totalling just under Euro 400 billion. Many European banks, exposed to these borrowers, also lost access to commercial funding becoming reliant on European Central Bank (“ECB”) loans. The need to guarantee the weaker countries inevitably increased the liabilities of the stronger countries, weakening them.
Greece, Ireland and Portugal will need debt restructuring. Spain and Italy are now firmly in the sights of markets. The bailout strategy cannot continue without affecting the creditworthiness of France and Germany. In the absence of continuing bailout, the European banking system, including the ECB itself, is vulnerable and will need capital from governments – economic catch 22!
The sovereign debt problem is global. The US, Japan and others also owe more than they can repay.
The recent rating downgrade of the US should not distract from the real issue – the quantum of US government debt and the ongoing ability to finance America. US government debt currently totals over $14 trillion.
Commentator David Rosenberg passionately described the problem: “In the past three years…we had the U.S. public debt explode by $5 trillion— the country is 244 years old and over one-third of the national debt has been created in just the past three years. Incredible. The U.S. government now spends $1.60 in goods and services for every dollar it is taking in with respect to revenues which is unheard of — this ratio never got much above $1.20, not even during the previous severe economic setbacks in the early 1980s and early 1990s.”
America has been able to run large budget and balance of payments deficits because it had no problems in finding investors in US treasury securities because of the special status of the US dollar are aglobal reserve currency. In recent years, the Federal Reserve itself also purchased around 70% of issues, under its quantitative easing programs. As foreign investors, especially China, become increasingly sceptical about the ability of the US to get its economy into order, the ability of America to finance itself is not assured.
Japan’s government debt to Gross Domestic Product (“GDP”) is over 200%. Tax revenues are less than half its outgoings, the remainder must be borrowed. The world’s largest saving pool has allowed Japan to manage till now. An aging population and a related slowing in its saving pool will make it increasingly difficult for Japan to finance itself in the future.
China’s headline debt to GDP ratio of 17% (around $1 trillion) is misleading. If local governments, its state controlled banks, state owned enterprise, and other government supported debt are included, then debt levels increase to 60% ($3.5 trillion), compared to America’s 93% of GDP. Some commentators argue that China’s real level of debt is far higher in reality, well above 100%.
At best, governments will cut spending or raise taxes to stabilise government debt as public-sector solvency becomes the priority. Reduction in government spending will slow growth, making the task of regaining control of government finances more difficult. This may require deeper cuts in governments spending and ever higher taxes, miring the developed world in low growth for a protracted period.
At worst, some governments overwhelmed by their debts will default, causing a major disruption in financial markets, perhaps setting off a deep global recession.
Government actions affected the financial economy far more than the real economy. Low interest rates boosted financial asset prices, while underlying economic activity remained weak.
Having shrunk by over 12% in 2008 and 2009, American output has yet to reattain its 2007 peak. On a per-person basis, inflation-adjusted basis, output stands at virtually the same level as in the second quarter of 2005 – in effect America has stood still for six years. The same is true of many countries.
Given consumption is 60-70% of individual developed economies, unemployment, under employment and lack on income growth will reduce growth.
In the four years since the recession began, the US civilian working-age population has grown by about 3% but the economy has 5% fewer jobs — 6.8 million jobs. The real unemployment rate – people without work, people involuntarily working part time, people not looking for work because there is none to be found – is around 15-20% in the US. Long-term unemployment has left millions of people out of work with poor prospects of finding jobs.
Americans in work are generally working less and, adjusted for inflation, personal income is down, not counting payments from the government like unemployment benefits. American household income has declined since the recession began in December 2007, falling to $49,445 in 2010, a total 6.4% decline.
According to latest figures, the number of American families living in poverty rose 2.6 million to 46.2 million, the largest increase since Census began keeping records 52 years ago. Income falls were particularly large for the less well off.
In 2010, the bottom fifth of households that make $20,000 or less saw their incomes decline 3.8% after inflation. Poor people, minorities were hit hardest. According to the National Women’s Law Center, the poverty rate for women climbed to 14.5% in 2010 from 13.9% in 2009, the highest level in 17 years. The extreme poverty rate for women jumped to an all-time high of 6.3% in 2010 from 5.9% in 2009. The poverty levels have reached the highest levels in over 15 years.
The same is true in Europe where the average official unemployment is above 10%. In many countries like Greece, Ireland, Portugal and Spain, unemployment is around 20%, youth unemployment is around 40-50%, as the economies have shrunk by 10-20%. Understandably, consumer spending is weak.
Key sectors, which employ workers, such as housing are frozen. In the US, housing starts are running around 400,000 to 600,000 units annually well below the level of the 1960s, down a staggering 70%+ from the peak and 50%+ from more normal levels.
With home prices down 35% from the peak and predicted to fall further, the Americans do not have a wealth buffer in housing equity to fall back on. Low interest rates and indifferent returns from investments mean that the ability of retirees to consume is also low. The same is true of many developed economies.
After a sharp decline in economic activity in 2008, emerging nations – China, India, Brazil and Russia– recovered through massive domestic investment, aggressive expansion of domestic credit and, in some cases, strong commodity prices. They benefited from the stimulus packages of developed nations, which helped fuel exports. Money fleeing the developed world looking for higher returns and elusive growth provided cheap and easy capital. That cycle is coming to an end.
China provides an example of the problems. Over-investment in infrastructure produced short term growth but many of the projects are not economically viable and will drag down future growth. Many are funded by debt that is already creating bad debts within the banking system, requiring diversion of funds to bail out troubled institutions.
Tepid growth in the US and Europe, its two largest trading partners, will slow Chinese exports. China’s foreign exchange reserves, invested in US and European government bonds and denominated in dollars and Euros, are increasingly worthless, as they cannot be sold and, if held, will be paid back in sharply devalued currency with lower purchasing power.
Printing money as the US has done, devalues the dollar creates additional pressure on China. Strong capital flows overwhelm smaller markets creating destabilising asset price bubbles.
Commodities traded in dollars increase in price creating inflation. Domestic inflation forces higher interest rates, slowing down the economy. The high proportion of spending on food and energy in emerging countries means a higher proportion of income is needed for essentials, reducing disposable income and creates wage pressures. These factors all choke off growth.
While improving American competitiveness and reducing its outstanding debt, a policy of devaluation of the US dollar may trigger trade and currency wars. There are already accusations of protectionism, currency manipulation and unfair competition. Many emerging markets have already implemented capital controls. These will be strengthened and supplemented by other measures such as trade sanctions. Even the Swiss National Bank recently announced moves to stop the flow of money into Swiss Francs seeking a safe haven, crimping growth and Switzerland’s exporter’s ability to compete.
Currency intervention may trigger tit-for-tat retaliation, reminiscent of the trade wars of the 1930s and will retard global growth.
Exit Via The Japanese Door …
Current concerns, most readily observable in wild gyrations of equity prices, are driven by the identified concerns but also the lack of credible policy options.
The most likely outcome is a protracted period of low, slow growth, analogous to Japan’s Ushinawareta Jūnen – the lost decade or two. The best case is a slow decline in living standards and wealth as the excesses of the past are paid for. The risk of instability is very high; a more violent correction and a breakdown in markets like 2008 or worse are possible. Frequent bouts of panic and volatility as the global economy deleverages –reduces debt- are likely. Problems created gradually over more than the last three decades can only be corrected slowly and painfully.
The eerie sound of the stick shaker can sometime be heard on cockpit voice recordings of doomed flights just before they crash. The global economy’s control stick is shaking violently. It remains to be seen whether the economic pilots can regain control and land the flight safely or whether it ends in a crash.