From late 2008 onwards, Government intervention, on an unprecedented scale, has been a dominant factor in economic matters.
Governments have spent aggressively, going into or increasing deficits, to increase demand within the economy to offset weak private sector consumption and investment.
Central banks have maintained low interest rates, pumped liquidity into the financial system and “warehoused” toxic assets to support the financial system. In the U.S., Fed holdings of MBS reached around $1 trillion. The purchases provided much needed liquidity to banks and reduced potential write-down on these securities. They also helped keep interest rates low and maintained the supply of housing finance.
The takeover of and government support for Government Sponsored Enterprises (“GSE”), such as the Federal National Mortgage Association (“FNMA” or Fannie Mae) and the Federal Home Loan Mortgage Corporation (“FHLMC” or Freddie Mac”), was an integral part of the process. The U.S. Government has now agreed to provided unlimited support to Fannie and Freddie.
Governments and central around the world followed the U.S. lead, implementing similar measures. Even emerging markets introduced aggressive cash transfer and make-work schemes allowing their fiscal positions to deteriorate. Brazil expanded its popular “Bolsa Familia” assistance scheme for poor families. India also expanded a program guaranteeing 100 days public work employment scheme in rural areas.
Financing these initiatives presents significant challenges. In the five quarters ending September 30, 2009, U.S. Treasury borrowing and outstanding GSE-guaranteed MBS increased by $2.8 trillion, a rise of around three times from the level of previous years. The U.K. and European countries increased public debt by similar or higher amounts (in percentage terms).
In 2009, investors readily bought large new issues of government debt, despite relatively low interest rates. Rating agencies maintained sovereign debt ratings for most major countries despite deteriorating public finances. Credit default spreads on sovereign debt for most issuers decreased in line with the general fall in credit margins. There were no outright auction failures.
Central bank purchases under ‘quantitative easing’(“QE”) (read printing money) programs helped the market absorb the volume of new issuance. According to estimates by Morgan Stanley, Fed purchases of assets, QE programs and other liquidity support programs reduced private sector net purchases of new Treasury issues to $200 billion in 2009. In 2010, in the absence of continued Fed support, private buyers will have to absorb $2,000 billion.
Large deficits are likely for some years. Continued spending and reduced tax income will ensure significant ongoing financing requirements. In the absence of a sharp and significant return of growth, the budgetary position will remain difficult. In many countries, the deficits are structural and not entirely related to the GFC.
In 2009, U.S. tax revenues fell 18% from previous year levels. 2009 U.S. state tax collections fell 13.3 % from 2008 levels, the highest decline in 46 years in terms of overall state tax collections as well as the change in personal income and sales tax collections. Tax revenue from financial services and housing are unlikely to recover for some time. Tax losses from the GFC will provide “tax planning” for many institutions for some years.
Central banks will find it difficult to dispose of their MBS holdings. They may remain on the central bank balance sheets for an extended period. Some securities may need to be held to maturity with underlying cash flows repaying the purchase price. These requirements will need to be financed without disrupting markets.
Foreign purchases of U.S. debt (the largest single borrower) have increased in dollar terms but decreased as a percentage of the total, as new issuance outpaces growth in demand. If the global economy slows and the inevitable adjustment in global imbalances takes place, the U.S. will purchase fewer foreign goods reducing foreign current account surpluses and the U.S. dollars available for purchasing future Treasury securities.
Chinese demand, which has underpinned recent foreign purchases, is uncertain in the future. Zhu Min, Deputy Governor of the People’s Bank of China, recently observed that “the world does not have so much money to buy more US Treasuries” He added that “the United States cannot force foreign governments to increase their holdings of Treasuries…“
While increasing domestic savings and mandatory purchases by banks may provide some demand, it is not clear where successive large deficits are to be funded. Most deficit nations face similar challenges.
Recently, large investors including Pimco, one of the world’s biggest bond fund managers, have reduced exposure to U.S. and U.K. government bonds, warning that the record levels of issuance is becoming increasingly problematic.
In 2009, there were three poorly bid U.S. government bond auctions. In December 2009, UK 10-year bond yields jumped 15 basis points (0.15% pa) (implying a capital loss of around 1.2% of principal) when the government failed to convince investors that they were prepared to tackle the country’s debt problems in their annual pre-Budget report. In late 2009, Japanese bond yields rose when the government indicated that it would not honour commitments to cap debt issuance next year.
Current initiatives mean that public debt in most countries, even many emerging markets, will increase sharply straining fiscal flexibility. For example, Japanese public debt is approaching 200% of GDP and government borrowing now exceeds tax revenues. In emerging markets, many new spending programs may prove difficult to discontinue politically.
The problems of government finances are not confined to national governments. In the U.S., the fiscal problems of major states, some larger than many countries, is well documented.
Ultimately, governments will have to balance the books. With projected public debt as of 2014 at or around 80-100% of GDP (with the dishonourable exception of Japan), the IMF estimates that just to maintain public debt levels, major developed economies will have to run budget surpluses of around 3-4% of GDP.
Ireland and Greece provide an insight into the actions necessary. In order to restore fiscal stability, the Irish government introduced a special 7% pension levy and implemented the toughest budget in the country’s history. Public sector salaries were cut between 5-15%. Unemployment and welfare benefits were also cut. More recently Greece proposed a program of similar budgetary austerity.
Credit rating agencies may downgrade sovereign borrowers. Many major government bond investors, such as central banks, soveriegn wealth funds, pension funds and asset managers, have investment mandates that limit them to ‘AAA’ and ‘AA’ securities. Central banks typically restrict the use of lower rated government bonds as collateral in repos (repurchase agreements) in secured borrowings. Downgrades below ‘AA’ may increase the difficulty for some countries to raise debt, particularly international markets.
Greece highlights the nature of the problem. The ECB can support government debt by buying unlimited amounts in the secondary market or financing purchase via repurchase agreements. The minimum rating for sovereign bonds eligible for repurchase agreements is currently ‘BBB-‘ (the lowest investment grade rating). At the end of 2010, the minimum rating will increase to ‘A-‘. Greece is currently rated ‘BBB+’ which means that in theory after 2010, the ECB cannot finance purchase of Greek bond if the rating does not improve or the ECB alters it criteria.
Lower ratings, irrespective of the eligibility issues, will increase the cost of borrowing that, in turn, will affect the ability to continue to finance government spending. In particular, the large outstanding stock of government debt means a large portion of the budget will need to be directed to servicing interest further restricting government spending on other initiatives.
The need to maintain the confidence of rating agencies and investors as well as access to markets may ultimately force the required disciplines. As James Carville famously observed: “I want to come back as the bond market. You can intimidate everybody.” Politicians everywhere will learn the reality in Thatcher’s terms: “You can’t buck the markets.“
Much of the strain on government debt is evident in currency markets. The decline in the value of U.S. dollar reflects, in part, the steady supply of U.S. Treasury bonds it must place with investors to finance it budget and trade deficits. Mohamed El-Erian, CEO of Pimco, observed on 19 August 2009 that: “The question is not whether the dollar will weaken over time, but how it will weaken. The real risk is that you will get a disorderly decline.“
Currency values are relative. The economic position of the U.K., Europe and Japan are hardly much better than the U.S. The small size of the markets in other currencies, such as the C$ and A$, limit their role in currency transactions. Many emerging market currencies, such as the Renminbi, are managed or artificially pegged limiting their use. The rise in gold – Keynes’ “barbarous relic” – reflects investor discomfort in any currency as much faith in its magical properties as a store of value.
Problems in government debt markets or disorderly volatility in currency markets remain significant risks to recovery.
Governments and central banks have dealt with symptoms but not addressed the underlying causes of the GFC.
The need to reduce the overall level of debt in certain economies has not been fully addressed. Public debt has been substituted for private debt. Despite some regulatory initiatives, many of the excesses of the financial system remain. The reliance of debt fuelled consumption and the related issue of global imbalance remains in the “too difficult basket“.
Few, if any, lessons have been learned, especially by bankers. Large bonuses are merely emblematic of a return to old practices. Leverage and pre-crisis lax lending conditions are returning in sections of the market. Lloyd Blankfein, CEO of Goldman Sachs, recently suggested that he was engaged in “God’s work.” At one level, the tax levied on major U.S. banks to recovery the cost of the bailouts and prescriptive rules to prevent engaging in risky activities reflect government frustration with the financial sector – “They just don’t get it!“
Reports of the demise of moral hazard are exaggerated. The debt of Nakheel, a property Group, was trading at 115% of face value shortly before its parent Dubai World announced a debt restructure in late November 2009. The prices did not reflect falling property prices or the real credit risk. Upon the announcement, the price fell promptly to below 50% but recovered to again over par when Abu Dhabi lent money to Dubai to help it make due payments. Markets continue to rely on state support despite the absence of explicit provisions to this effect.
Policies assume that the problems relate to temporary liquidity constraints resulting from non-functioning markets for some financial assets. They fail to acknowledge the severity of the problems and the extent to which the previous high prices of some assets reflected excessive liquidity that overstated their true value. Policy makers assume that liberal application of liquidity – financial botox – represents a permanent cure. In Albert Einstein’s words: “You can never solve a problem with the thinking that created it“.
At best, governments are hoping that loose money will create inflation allowing reflation of asset prices alleviating the worst of the problems. The morality of punishing savers and rewarding excessive borrowing has not been debated.
The reflation hypothesis itself may be flawed. Inflation probably needs convergence of several conditions – excessively loose money supply, active lending by banks to increase the velocity of the money and an imbalance between supply and demand.
Loose money supply by itself may not be sufficient to create inflation. In Japan, years of loose monetary policy and quantitative easing have not prevented significant deflation over the last two decades.
The other conditions are not currently observable. Problems within the financial system have slowed the velocity of money. Capacity utilisation is generally low and over capacity exists in many industries.
Excess capacity is being increased by government actions. Support for industries, such as the automobile manufacturers, prevents required adjustments to capacity. At the same, government spending, for example in China, is increasing capacity in anticipation of a return of demand. If demand does not re-emerge, then there is a risk that excess capacity may exert deflationary pressures. Further trade problems, through dumping and other defensive trade tactics, may also result.
In the short term, high levels of inflation appear unlikely. Higher energy and food prices have prevented outright deflation in recent times.
These two items represent a high proportion of spending in emerging markets. High energy and food costs reduce available disposable income reducing demand of other products at a time when these economies are trying to increase consumption.
Given that re-risking assumes high inflation, changes in inflationary expectations may affect asset markets and in turn the path of the recovery.
The last few decades have seen an economic experiment where increasing levels of debt have been used to promote high growth. This policy had the unintended consequence of increasing risk in the global economy, which was not fully understood by the individual entities taking this risk or regulators and governments.
This experiment is now coming to an end. In the post World War II period, the U.S. and global economy enjoyed strong growth and increasing living standards. Despite higher debt levels, economic growth and improvements in income and wealth have slowed significantly.
For the U.S., the first decade of the 21st century – the noughties – have been disappointing. Economic growth has been the slowest in the post war era. There has been no net job creation over the decade. Median income and in particular income levels for middle income earners declined in real terms. Household net worth, representing the value of their house, pensions and other savings, also declined.
A similar pattern is evident in many developed economies. Emerging countries and their citizens have done better but off lower base levels.
Some of the money, largely borrowed, was invested in assets that produced and will produce little, relative to the prices paid. This includes overpriced housing (the “MacMansions”), commercial real estate and consumer “must-haves”. Investment in these assets distorted economic activity around the globe. The excesses must be worked-off. The problems are pervasive. Few groups – consumers, businesses, governments – or countries are unaffected.
The real risk is of long-term economic stagnation. A period of low growth, high unemployment or underemployment and over capacity is possible while individuals, firms and governments repair balance sheets.
It is not clear that markets and investors are assuming prolonged adjustment, preferring to focus on the rates of change in key indicators. As Mervyn King, Governor of the Bank of England, noted: “It’s the level, stupid – it’s not the growth rates, it’s the levels that matter here.“
Bad Love …
The financial market rally may not be over. There is a chance of a melt-up before any meltdown. Riding an irrational price bubble is sometimes an optimal investment strategy for even rational investors As an unnamed banker told Charles MacKay, author of the 1841 book Extraordinary Delusions and the Madness of Crowd (1841): “When the rest of the world is mad, we must imitate them in some measure“.
Governments may introduce provide further support if economic and financial setbacks occur. Further fiscal stimulus packages are likely to be unveiled. Credit Suisse’s Neil Soss summed up the monetary policy position succinctly: “Central banks … have maxed out the amount of ‘love’ they’re willing/able to give. … They probably won’t take away much, if any, of the “love” they’re giving us now in terms of low short-term interest rates and large central bank balance sheets for quite some time, but the change in momentum from ‘more love’ to ‘no incremental love’ is palpable and bound to influence markets.“
The risk of policy errors is ever present. Inopportune withdrawal of support or policy mistakes have the potential to be destabilising. High levels of volatility are likely to persist.
Governments and central banks continue to inject liberal amounts of botox to cover up problems, at least, while supplies exist. In absence of any definite solutions, policymakers are deferring dealing with the problems, rolling them forward. This means that the unavoidable adjustment when it occurs will be more severe and more painful. The ability of policymakers to cushion the adjustment will be restricted by constrained balance sheets.
In the words of David Bowers of Absolute Strategy Research: “It’s the last game of pass the parcel. When the tech bubble burst, balance sheet problems were passed to the household sector [through mortgages]. This time they are being passed to the public sector [through governments’ assumption of banks’ debts]. There’s nobody left to pass it to in the future.“
The exact trigger to end the current period of optimism is unpredictable. While several areas of stress are apparent, as Keynes observed: “The inevitable never happens. It is the unexpected always.”
The summary of 2009 and the outlook for 2010 may be the logo on a black T-shirt worn by Lisbeth Salander, the heroine of Steig Larsson’s Girl with the Dragon Tatoo: “Armageddon was yesterday – Today we have a serious problem.“
Originally published at Eurointelligence and reproduced here with the author’s permission.
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