Armageddon was yesterday — Today we have a serious problem

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.

Central banks have maintained low interest rates, pumped liquidity into the financial system and warehoused toxic assets to support the financial system. Central bank purchases under quantitative easing (read: printing money) programmes helped the market absorb the volume of new issuance. According to estimates by Morgan Stanley, Fed purchases of assets, QE programmes and other liquidity support programmes 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.

Governments and central banks around the world followed the US 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 expanded NREGS.

In 2009, investors readily bought large new issues of government debt, despite relatively low interest rates. Rating agencies maintained sovereign debt ratings, especially for major countries despite deteriorating public finances.

Large deficits and slow growth
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 US budgetary position will remain difficult. Foreign purchases of US debt have increased in dollar terms but decreased as a percentage of the total, as new issuance outpaces growth in demand.

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 US and UK gilts, warning that the record levels of issuance is becoming increasingly problematic.

Current initiatives mean that public debt in most countries, even many emerging markets, will increase sharply straining fiscal flexibility.

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, Greece and Spain 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 and Spain proposed austerity programmes focused on major spending cuts and tax increases. The impact of such fiscal programmes on growth and social harmony is likely to be severe.

Credit rating agencies may downgrade sovereign borrowers. Lower ratings 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.

Focus in the short run will be on the ‘PIGS’ (Portugal, Ireland, Greece, Spain). Net external debt of the PIGS is: Portugal €177 billion (108% of GDP), Ireland €123 billion (68 % of GDP), Greece €208 billion (87% of GDP), Spain €950 billion (91% of GDP). If the risky debt of Eastern European countries is added, the total amount of debt in question approaches €2 trillion. In the longer term, attention will shift, inevitably, to major economies with high levels of government debt — the ‘FIBS’ (France, Italy, Britain, States). At least Japan has its very large pool of domestic savings.

Everything remains the same 
Governments and central banks have dealt with symptoms but not addressed the underlying causes of the global financial crisis. 

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”.

Policies assume that the problems relate to temporary liquidity constraints resulting from non-functioning markets for some financial assets. They fail to acknowledge the extent to which the previous high prices of some assets reflected excessive liquidity that overstated their true value. 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 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. For the US, 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.

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.

Rolling forward problems
The financial market rally may not be over. There is a chance of a melt-up before any meltdown. Riding irrational price bubbles 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”.

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 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.”

The writer is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives - Revised Edition (2010), to be released in India in May