October 1, 2011
October 1, 2011
The GFC Was Never Really Over…
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. 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. Like individuals and companies, governments did not always use borrowed money for productive purposes, fuelling consumption and making poor investments.
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 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 is vulnerable and will need capital from governments – 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.
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 as a global 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.
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.
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.
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. Even those Americans in work are generally working less and, adjusted for inflation, personal income is down 4% percent, not counting payments from the government like unemployment benefits.
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. That too is coming to an end.
In China, 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 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. These factors all choke off growth.
The policy of devaluation of the US dollar may trigger trade and currency wars, 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.
Satyajit Das is author of Traders, Guns and Money: Knowns and unknowns in the dazzling world of derivatives (August 2006) and Extreme Money: The Masters of the Universe and the Cult of Risk (August 2011)