Satyajit Das Presents a Global Economy Health Check
Mr. Global Economy gets a metaphorical physical and psychological examination. Here are the results.
The patient’s history includes a seizure in 2007/ 2008 including financial losses, banking problems, a major recession, etc. Liberal injections of tax payer cash avoided catastrophic multiple organ failure, and assisted a modest recovery.
Governments ran large budget deficits in the period after the crisis. Interest rates around the world were reduced to historic lows; some were even reduced to zero in many developed countries.
With interest rates constrained at zero, central banks have adopted "innovative” treatments, referred to as quantitative easing, which is the fashionable appellation of a more old fashioned procedure – printing money. Balance sheets of major central banks have increased from around US$6 trillion to US$18 trillion, an unprecedented 30% of global gross domestic product (“GDP”).
As evident from the anticipation of and reaction to decisions by the US and European central bank to provide further support, the global economy is now addicted to monetary easing. Increasing doses are necessary for the patient to function at all.
Mr. Economy has also not made the recommended changes necessary for a return to full health. He seems to have taken rock star Steven Tyler’s advice: “Fake it until you make it.”
Borrowing levels remain unsustainable. Debt levels for 11 major nations have increased from 381% of GDP in 2007 to 417% of GDP in 2012. Debt has increased in Canada, Germany, Greece, France, Ireland, Italy, Japan, Spain, Portugal, the UK, and the US.
There has been a shift of debt from private borrowers to governments. There has also been a change in the identity of the lender – governments and central banks have heroically stepped in to take over debt from commercial lenders and investors.
Global imbalances – major current account surpluses and deficits – remain. Large exporters like China, Japan, and Germany remain resistant to abandoning their export-based economic model.
Little progress has been made in bringing the banking system under control. Regulatory initiatives involve activity if little achievement. New regulations of stupefying complexity run to thousands of pages.
The process provides continuing employment to thousands of needy policy advisors, regulators, lawyers, and lobbyists who would otherwise struggle to gain productive employment. Without their heroic efforts and stoic acceptance of privations (first class travel, five-star hotels, constant conferences and symposiums, etc.), the recovery would be even more tepid.
Major Organs – US
Physical examination revealed that the US is in marginally better condition than other organs – the “cleanest dirty shirt” is the expression. Despite a US$1 trillion annual budget deficit (6% of GDP) and zero interest rates, growth is a tepid 2%.
The housing market’s rate of descent has been arrested, but prices remain 30%-60% below highs. New housing starts have stabilized at around 50% below peak levels. Benefiting from a weaker dollar, manufacturing has improved. Lower oil and natural gas prices have benefited the economy.
Employment remains weak. If discouraged workers who have left the workforce and part-time workers seeking full time employment are included, then unemployment is over 15%, well above the headline 8% rate. The total number of Americans now employed is around 140 million, well below the peak level above 146 million.
Consumer spending remains patchy. Job insecurity, lack of earnings, and wealth losses are causing households to reduce spending and repay debt.
Record corporate profits have been achieved mainly through cost reductions and minimal revenue growth. Investment is weak due to the lack of demand.
Bank lending is sluggish due to lower demand for credit and problems of financial institutions.
Federal public finances remain unsustainable. Hardening of the political arteries means that there is little resolve to deal with deep-seated problems. There is the risk of a “fiscal cliff” episode.
If there is no political resolution, then automatic tax increases (non-renewal of tax cuts) and spending cuts equivalent to about 5% of GDP, mandated under the 2011 increase in the national debt ceiling, will automatically occur. This would mean a contraction equivalent to more than US$600 billion in the first year and US$6.1 trillion over 10 years. This would improve the budget deficits and slow the growth in debt, but adversely affect growth.
State and municipal finances are also under stress, with an increasing number of borrowers filing for bankruptcy.
Other Developed Organs
Many European countries have high debt levels, budget and trade deficits, social spending inconsistent with tax revenues, poor industrial competitiveness (with some exceptions), a rigid monetary system, and inflexible currency arrangements. This is compounded by weaknesses of the European banking system with large exposure to sovereign bonds issued by peripheral nations.
Intellectually and institutionally, Europe is unable to deal with its debt crisis. Europeans believe stabilization and recovery can be achieved through greater integration. Even if issues of national sovereignty can be overcome, integration will not work. Unsustainable levels of debt do not magically become sustainable by changing the lender or guarantor. The monetary arithmetic of European debt problems is that the EU and Germany, its main banker, do not have enough funds to rescue the beleaguered eurozone members.
Austerity dooms Europe to a prolonged and severe recession as the debt burden is worked off. The alternative, a debt write-off, would result in a significant loss of wealth for the mainly Northern European lenders, which would trigger an economic contraction and a prolonged period of economic stagnation.
Japan is in a state of advanced atrophy, despite decades of therapy. The temporary rebound, mainly the result of the recovery from the tragic tsunami and government spending, is running out of steam. The political system is even more blocked than that of the US, allowing only a trickle of oxygen to circulate, thus impairing function.
Japan’s primary investment merit is that almost all possible man-made and natural disasters have happened and the worst is factored in.
Mr. Economy’s physicians originally hoped that the BRIC (Brazil, Russia, India, and China) nations would offset weakness in more developed and weaker elements. Unfortunately, China’s growth is slowing rapidly. India and Brazil have also lost momentum, with growth weakening. Russia is dependent on high energy prices.
BRIC weakness is a function of lower demand from developed countries reducing exports and weaker commodity prices.
The withdrawal of European banks, which are historically major lenders to emerging markets, has decreased the flow of money to countries needing foreign investment. For example, in 2011, large European banks accounted for 36% of global trade finance, based on a World Bank study. 40% of trade credit to Latin America and Asia was provided by French and Spanish banks. As the European banks, besieged by financial problems at home, reduce their international activities, the supply of financing has decreased and its cost has increased.
Emerging markets also show increased susceptibility to the developed world credit virus. A rapid expansion of domestic credit in China, Brazil, Eastern Europe, Turkey, and India will result in banking system problems. The combination of external and internal weaknesses threatens emerging economies, which are naturally prone to serial crises.
As requested, our psychiatrist has assessed the psychological condition of Mr. Global Economy.
He concluded that Mr. Economy is delusional, believing complete recovery is imminent. Presented with contrary evidence, he quoted philosopher Friedrich Nietzsche: “There are no facts, only interpretations.”
Like many terminally ill patients, Mr. Economy has embraced faith-healing techniques. Keynesian and monetarist regimes, he believes, will boost demand and create sufficient inflation to bring his elevated debt levels under control.
The Keynesian cure entails government spending financed by taxation or borrowing to restore Mr. Economy’s health. There is no evidence that it can arrest long-term declines in growth.
Government spending boosts activity temporarily, but may create excess capacity in the absence of underlying demand. Nostalgia about President Roosevelt’s infrastructure projects during the Great Depression is misplaced. Excess electricity generation capacity from dam projects was only absorbed by wartime demand for defense equipment.
As tax revenues have fallen due to slower economic activity, governments have already borrowed to finance large budget deficits.
The government's ability to borrow to finance further spending is increasingly limited, without resorting to the innovative monetary techniques. In recent years, the US Federal Reserve has purchased around 60%-70% of all US government debt issued. The European Central Bank is now financing governments indirectly by lending to banks to purchase sovereign bonds.
The ability of the US to finance its large budget deficit relies heavily on several unique factors. The US Federal Reserve and the banking system flush with central bank funds have been a large purchaser of US government bonds. The status of the US dollar as the major trade and reserve currency has allowed the US to find buyers of its securities, even at very low interest rates.
The limits of the government’s ability to borrow and spend are highlighted by the European debt crisis. Investors are increasingly concerned about public finances, and becoming reluctant to finance nations with high levels of debt or demanding high interest rates.
Having reduced interest rates to zero, central banks are giving Mr. Economy the modern monetarist prescription, changing the quantity of money available. Under quantitative easing, they buy government bonds, thus injecting money into the banking system to lower borrowing costs and increase the supply of money to stimulate demand and inflation. Central banks believe that they can keep rates low and print money to finance government debt purchases indefinitely.
But greater government spending, lower rates, and increased supply of money may not boost economic activity. Crippled by existing high levels of debt, low house prices, uncertain employment prospects, and stagnant income, households are reducing, not increasing, borrowing. For companies, the absence of demand and, in some cases, excess capacity means that low interest rates are unlikely to encourage borrowing and investment.
Loose monetary policies may not also create the hoped for inflation that is needed to lower real debt levels. Banking problems and the lack of demand for credit means that the essential transmission mechanism is broken. Banks are not using the reserves created and money provided to increase lending. The reduction in the velocity of money or the rate of circulation has offset the effect of increased money flows. The low velocity of money, the lack of demand, and excess productive capacity in many industries means the inflation outlook in the near term remains subdued.
The treatments being used have serious side effects. Low rates involve a transfer of wealth from investors to borrowers, with the lower coupon payment acting as a disguised reduction of the principal amount of the loan. They provide an artificial subsidy to financial institutions, allowing them to borrow cheaply and then invest in higher yielding safe assets such as governments bonds.
Low rates discourage savings, creating a disincentive for capital accumulation. They encourage mispricing of risk and feed asset bubbles, such as that for income (high dividend paying shares and high yield low grade debt) as well as speculative demand for commodities and alternative investments.
Low policy interest rates have created massive unfunded pension liabilities for governments and companies. In the US, S&P 1500 companies have aggregate pension deficits of US$543 billion, an increase $59 billion in the first half of 2012.
In the long run, economies become dependent on low rates as high debt levels cannot be sustained at higher borrowing costs.
Internationally, low interest rates distort currency values and also encourage volatile and destabilizing short term capital flows as investors search for higher yields. Attempts by nations to increase their competitive position by weakening their currency also threaten tit-for-tat currency wars, trade restrictions and barriers to investment flows.
The faith-healing cures provide symptomatic relief, but do not address fundamental problems such as the high debt levels, lack of demand, declining employment, lack of income growth, or the problems of the banking system. It is not clear how if at all any of the cures being pursued can create real ongoing growth and wealth to restore Mr. Economy’s health.
Limits to Knowledge
The number of medical advisors involved and variety of drugs – stimulus, austerity, quantitative easing, leeches, cupping, witchcraft – is unhelpful. While doing nothing is politically and socially impossible, the treatments may be doing more harm than good. As French playwright Moliere noted, “More men die of their remedies than of their illnesses.”
Interestingly, these same faith healers until recently oversaw Mr. Economy, prescribing regimes that caused the present financial and economic calamity. Perhaps like writer Samuel Beckett, they are keen to fail better next time.
There is no recognition of the limits to knowledge and policy tools. Economic relationships are poorly understood, complex, and unstable. Cause and effect is uncertain. Does money supply influence nominal income or does nominal income affect velocity and the demand for and thereby the supply of money? The ability of governments and central banks to influence economic activity is overstated. As economist Wynn Godley put it: “[G]overnments can no more control stocks of either bank money or cash than a gardener can control the direction of a hosepipe by grabbing at the water jet.”
To paraphrase Voltaire’s observation on doctors, Mr. Economy’s faith healers prescribe medicines of which they know little, to cure diseases of which they know less, in economic and financial systems of which they know nothing.
Prognosis for Mr. Economy
Mr. Economy now has a serious chronic condition with limited prospects of a full cure. He might continue to live but in an impaired state with no or low growth for a prolonged period. The threat of a sudden life-threatening seizure cannot be discounted. Constant management will be needed.
Happily, Mr. Economy remains remarkably optimistic. Perhaps he recognizes the truth of Mark Twain’s observation: “Don't part with your illusions. When they are gone, you may still exist, but you have ceased to live.”
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