Mr. Global Economy – Health Check

As requested, I have undertaken an extensive examination of Mr. Global Economy, both physical and psychological.

Patient History…

The patient’s history includes a seizure in 2007/ 2008 –financial losses, banking problems, a major recession etc. Liberal injections of tax payer cash avoided catastrophic multiple organ failure assisting a modest recovery.

Governments ran large budget deficits in the period after the crisis. Interest rates around the world were reduced to historic lows, zero in many developed countries.

With interest rates constrained at zero, central banks have adopted “innovative” treatments, referred to as quantitative easing; 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 heroin. Increasing doses are necessary for the patient to function at all.

Lifestyle Changes…

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 advisers, regulators, lawyers and lobbyists, who would otherwise struggle to gain productive employment. Without their heroic efforts and stoic acceptance of privations (first class travel, 5-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 reducing 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 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, 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, does not have enough funds to rescue the beleaguered Euro-Zone 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 significant loss of wealth for the mainly Northern European lenders triggering an economic contraction and prolonged period of economic stagnation.

Japan is in a state of advance 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 the US allowing only a trickle of oxygen to circulate, 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.

Emerging Parts…

Mr. Economy’s physicians originally hoped that the BRIC (Brazil; Russia, India; 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, that 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, naturally prone to serial crises.

Psychological Assessment

As requested, Dr. Freud 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.

Keynesian Kool-Aid…

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 defence equipment.

As tax revenues have fallen due to slower economic activity, governments have already borrowed to finance large budget deficits.

Government ability to borrow to finance further spending is increasingly limited, without resort 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 US ability to finance is also underpinned by the balance of financial terror – overseas buyers, such as China, Japan, major oil producers are forced to continue purchasing US government debt to avoid loss of value on existing large holdings.

The limits of government’s ability to borrow and spend are highlighted by the European debt crisis. Investors are increasingly concerned about public finances, becoming reluctant to finance nations with high levels of debt or demanding high interest rates.

Monetary Boosters…

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 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, 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.

Side effects…

The treatments being taken have serious side effects. Low rates entail 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 destabilising 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 – 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 advisers 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: “governments 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 of 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”.

9 Responses to "Mr. Global Economy – Health Check"

  1. Richard Wood   October 9, 2012 at 4:54 pm

    Satyajit,

    Very excellent summary of current failing policies, but short on positive prescriptions. Please contact Richard at [email protected]

    • Allan Mountain   October 13, 2012 at 3:55 am

      Previous reply was in haste and omitted a far better alternative

      There has in fact been enough historic precedent to confirm that the best option / prescription to the current debacle would be a totally free banking market, allowing people to use a choice of privately managed currencies of their choice. Yes there is historic precedent.

      Here are two articles worth reading on the subject:

      ‘Free Banking’ by George Selgin, Professor of Economics, The Terry College of Business, University of Georgia (following is url link to both audio and text download of his presentation on the subject of Free Banking)

      refer: http://www.econtalk.org/archives/2008/11/selgin_o

      and

      'Saving the World from Governments and Banks'
      By Dominic Frisby, Contributing Writer, Money Morning 13 October 2012

      refer: http://www.moneymorning.com.au/20121013/saving-th

  2. Allan Mountain   October 10, 2012 at 10:48 pm

    That is because there are no positive prescriptions.

    The only sensible thing to do would be for governments and banks to default on all debt. Shut down the central banking scam and the BIS.

    Then nations refomulate a gold and silver backed global currency system with no one currency dominating, as the USD (Petrodollar) currently does.

    Instead of bailing out the bankers, governments should, in this sceanrio, reimburse/back all the business and small investors and ensure the integrity of their current bank deposits.

    The new system would see governments controlling issuance of debt-free money and not some privately-owned banking cartel.

    Sounds too easy I know. But we will soon see the very ugly and painful alternative unfold with much dire consequences unless some dramatic and drastic action is taken to stop this current bank-rigged fraud from creating a sudden and cataclysimc systemic crash that will lead to an unimaginable social break-down followed by the usual fall-back to a devastating global conflagration.

    Sadly I am betting on the pernicious greed and criminality of the ensconced incumbent powers to bring about the latter scenario.

    I hope I am wrong

  3. Salvatore Iro   October 25, 2012 at 3:46 am

    Around the world there are thousands (hundreds of thousands ?) of Economics professors and economy experts with multiple BAs, MBAs, PhDs.
    Having all this knowledge available, how is it possible the world is having to face such a dramatic situation:
    – global economic downturn
    – unsustainable ever reached debt level
    – massive galloping unemployment in the West
    – no sound remedies.

    How is that possible ?
    Apparently, knowledge is not so helpful. Or, on the contrary, is knowledge what has brought us to this miserable point ?

    How is it possible that, meanwhile macro economic indexes are crying bitter tears, the oil and financial industries performances indexes are exulting?

    How is knowledge being used in our world ?
    Can we state that the education system (producing and fueled by economy experts with multiple BAs, MBAs, PhDs) is the cause of the economic ravages of the world?

    Would this be a good track to find a sound remedy ?

  4. Salvatore Iro   October 25, 2012 at 6:59 am

    "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?"

    Dear Das,
    the statement above is exactly what they teach you at school (may it be Harvard or the Katmandu college, the same).
    However, what they will never teach you at school is that economy is a human construction, that what really matters is just: 1. resources and 2. the ability to transform them.
    The rest (the way 1. and 2. are distributed and rewarded) is human nature dilemmas: power relations, ownership arrangements.
    Therefore economy is just a superstructure; underneath this structure is human fear/courage, egoism/altruism, violence/love, war/peace, …

    This is why the problem is not if knowledge to find remedies to the world's problems is limited or not, as knowledge is a constantly evolutive variable, so it is always limited and limit-less at the same time. The problem is rather the "knowledge bias".

    What is the actual knowledge bias ?
    The dominant knowledge is the knowledge you would learn today in a place like Harvard. The rest of the world education system is just following.
    What is the bias of the dominant economic knowledge? Its bias is: "take advantage of". Of ? Of natural and human resources and of knowledge itself. Dominant economic knowledge is not animated by the concern "how to make the world a better place for humanity". If that was the case, we would have never imagined such sophisticated inventions like future derivates, sub-primes, commodity speculations or the Cayman Islands. Harvard's professors are so good in modeling such tricks sold off as progress, aren't they?

    What I want to say is that, if we change the bias of the education system, we can may be change the world economy for the better. That will take a few decades. But isn't it better than a scenario of global impoverishment and war for resources between the old and the developing world ?

  5. 16Nov16   October 25, 2012 at 11:12 am

    I have just read Satyajit's article in today's FT, which draws much of its theme from this much longer blog.

    He writes with a wonderful clarity of expression and each sentence is loaded with meaning. Unfortunately, all that he says makes enormous sense and you have to feel rather gloomy about the prospects for the world economy. What are we doing with our kids' inheritance?

  6. guest   November 4, 2012 at 3:48 pm

    Oh the answer to the problem is so easy. All economic entities in the world (including governments) have to live within their means or else go bankrupt. Otherwise they scew up everyone else…