Ever since the first rounds of quantitative easing (QE) by the US Federal Reserve, I’ve raised questions about how sound and sustainable this form of monetary policy is? How big is the risk that the greatest economic experiment in modern history may eventually fail? More than three years later, I’m still not sure. The only thing I’m sure of, is that the need for extreme measures is greater than ever.
“It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution. What matters is growth.”
George Irvin
(Photo by freakingnews.com)
While Mr. Ben Bernanke in the USA is trying to figure out new and more creative ways to flow the financial system with money in order to kick-start the nation’s economy, European politicians are obsessing over new and creative austerity measures in order to save money and regain the union’s financial balance. But nothing seems to work.
In 2008 I called for the launch of a so-called “Keynesian war” – but with a twist:
Instead of increasing public spending the traditional way, by investing in infrastructure like transport and housing or by upgrading public institutions like the military, I suggested to aim the financial “guns” at research and education, closing the gap between the rich and the poor, and developing clean energy.
The “Keynesian war” was launched, all right. But the ammunition was poured into the banks and other financial institutions who barely manged to save their own asses, in addition to dump the problems on their respective national governments.
The financial crisis is currently well beyond the stage I regarded as a “worst-case-scenario” only two years ago.
So, where do we go from here?
One thing ought to be clear: It’s no longer a question of method – the only thing that matters is the result.
Honorary professor George Irvin at University of London makes a pretty good summary in his latest blog post at the EUobserver.com.
The Debt Trap
“Europe is obsessed with the growing stock of public sector debt; fiscal austerity has become the watchword of our time. Little does it seem to matter that fiscal austerity means reducing aggregate demand, thus leading to economic stagnation and recession throughout the EU as all the main forecasts are now suggesting,” Professor Irvin writes.
Even the credit rating agencies are worried, as S&P’s downgrading of France and eight other countries shows. Whether it’s Angela Merkel or David Cameron speaking, public debt is denounced as deplorable, and all are told to get used to hard times.
As Larry Elliot puts it:
“The notion that economic pain is the only route to pleasure was once the preserve of the British public school-educated elite, now it’s European economic policy”.
In Britain, immediately after the general election, the Tory-led coalition decreed that in light of the large government current deficit, harsh cuts were necessary to win the confidence of the financial markets.
But although the current deficit was high, the stock of debt (typically measured by the debt/GDP ratio) was relatively low and of long maturity, the real interest rate on debt was zero (and at times negative) and, crucially,
Britain had its own Central Bank and could devalue. As Harriet Harman argued in June 2010, Osborne’s cuts were ideologically motivated. The aim was to shrink the public sector, and the LibDems—fearing a new general election—chose to go along with the policy.
In the euro zone (EZ), where a balance of payments crisis at the periphery has turned into a sovereign debt crisis, the German public has been sold the idea that if only all EZ countries could be like Germany and adhere to strict fiscal discipline, all would be well.
The ultra-orthodox Stability and Growth Pact (SGP) has now been repackaged under the heading of ‘economic governance’ under which Germany and its allies will vet members’ fiscal policies and impose punitive fines on those failing to observe the deflationary budget rules to be adopted.
Never mind the fact that indebtedness in countries like Spain and Ireland was mainly private, or that the draconian fiscal measures imposed on Greece have, far from reducing public indebtedness, increased it.
Is debt always a bad thing?
In the private sector, obviously not since corporations regularly borrow money for expenditure they don’t want to meet out of retained earnings, while most households aim to hold long-term mortgages.
Public debt instruments like gilts in the UK or bunds in Germany are much sought after by the private sector, mainly because such instruments are thought to act as an excellent hedge against risk.
Remember, too, that when a pension fund buys a government bond, it is held as an asset which produces a future cash stream which benefits the private sector.
So ‘public debt’ is not a burden passed on from one generation to the next.
The stock of public debt is only a problem when its servicing (ie, payment of interest) is unaffordable; ie, in times of recession when growth is zero or negative and/or interest rates demanded by the financial market are soaring.
The question is when is debt sustainable?
Sustainability means keeping the ratio of debt to GDP stable in the longer term.
If GDP at the start of the year is €1,000bn and the government’s total stock of debt is €600bn, then the debt ratio is 60%; the fiscal deficit is the extra borrowing that the government makes in a year – so it adds to the stock of debt.
But although the stock of debt may be rising, as long as GDP is rising proportionately, the debt/GDP ratio can be kept constant or may even be falling.
Consider the following example. Suppose the real rate of interest on debt is 2% (say 5% nominal but with inflation at 3%, so 5 – 3 = 2). That means government must pay €12bn per annum of interest in real terms. But as long as real GDP, too, is rising—say at 2% per year—there’s no problem since real GDP at the year’s end will be €1020bn.
Even if the government were to pay none of the interest, the end-of-year debt/GDP ratio would be 612/1020 or 60%; ie, the debt ratio remains unchanged.
By contrast, if real GDP growth is zero, the ratio would be 612/1000 = 61.2; ie, the debt ratio rises only slightly.
The rule is that as long as the real economy is growing by at least as much as the real rate of interest on debt, the debt/GDP ratio doesn’t rise.
Moreover, this holds true irrespective of whether the debt ratio is 60% or 600%.
But there’s a catch.
In a modern economy, the public sector accounts for about half the economy.
If a country panics about its debt ratio and cuts back sharply on public sector spending, this reduces aggregate demand and may lead to stagnation or even recession.
When a country stops growing, financial markets decide that its debt ratio may rise and so become more cautious about lending and demand a higher bond yield (ie, interest rate).
The gloomy prophecy of growing public indebtedness becomes self-fulfilling. This is exactly the sort of “debt trap” which faces much of the EU and other rich countries. The way out cannot be greater austerity.
What works for a single household or firm doesn’t work for the economy as a whole. A household can tighten its belt by spending less, saving more, and thus ‘balancing the books’, but an economy cannot.
If everybody saves more, national income falls.
Of course, Germany and some Nordic countries can balance the government books because an export surplus offsets domestic private saving. But the Club-Med countries cannot match them.
When no EZ country can devalue, to ask each EZ country to balance the books by running an export surplus is empirically and logically impossible.
Even if all could devalue, what would follow is 1930’s-style competitive devaluation.
The way out of the ‘debt trap’ is the same as the way out of recession: if the private sector won’t invest, the public sector must become investor of the last resort.
It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution (some combination of the three would be optimal).
What matters is growth.
By George Irvin
George Irvin is a retired professor of economics and for many years was at ISS in The Hague. He is now honorary Professorial Research Fellow in Development Studies at the University of London, SOAS.
Related articles:
- Is there an austerity curve? (stumblingandmumbling.typepad.com)
- Notes On Deleveraging (krugman.blogs.nytimes.com)
- The Nordic cure for a hangover (economist.com)
- More QE is not the antidote to the eurozone crisis (telegraph.co.uk)
- When, oh when, will Europe face the truth? (telegraph.co.uk)
- Needed Projects + Low Interest Rates + Low Construction Costs + New Jobs = Smart Debt (slog.thestranger.com)
- West – Developed & Deep in Debt (quicktake.wordpress.com)
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Probably one of the best indications of how deep the knowledge of economic and financial issues are (in general) amongst our political leaders, sadly.
No Hope For The Dollar?
A very ugly batch of data today from the US, particularly the new spike in jobless claims, will have the market cooking up fresh imaginings of QE to infinity. Here’s a fresh update from Saxo Bank.
“At some point, it becomes a very fearsome thing to contemplate a disorderly demise of the world’s reserve currency and what that could mean for the world’s markets.”
John J. Hardy
It’s a perfectly timed question, as the USD struggle to recover from a three-year low, and the US FED signals zero interest rate practically forever if necessary. So, what does Thursday’s data mean for risk appetite and for the USD – could it be slightly supportive in the near term, or is there simply no hope for the greenback?
“Remember in our look at the last couple of FOMC meetings, that the pattern we saw in both rates and in the USD. Those meetings produced a short additional weakening in an already weak USD, followed by a period of consolidation. So far, the pattern is holding,” FX strategist John J. Hardy writes in an update.
Adding: “This time around, Bernanke did all he could to make us all want to run out and buy survival supplies and alternative investments with every greenback we could scrounge up. The question is what percentage of the market has waited until this point to get short of the USD, considering the very stretched move we have seen up to this point. In the nearest term, in other words, there could be more risk of a two-way market developing as long as the market’s largest participants (central banks and others) don’t press the panic button.”
A Disorderly Demise of the Dollar?
But beyond the immediate term, we have to wonder, Saxo Bank concludes.
“As our Chief Economist pointed out in a column this morning, whether this latest performance from Bernanke and company raises the risk of a true USD crisis rather than just a USD slide. While this game of everything up versus the greenback has so far been a relatively risk benign development – at some point, it becomes a very fearsome thing to contemplate a disorderly demise of the world’s reserve currency and what that could mean for the world’s markets,” Hardy writes.
Odds and ends
It is increasingly clear from the stream of data from Japan that the economy took a very serious hit.
The overall household spending level for March was out overnight at -8.5% YoY and the Industrial Production figure for the month was down a stunning -15.3% MoM.
These data only include the effects of the first three weeks of the crisis.
“The market may be willing to give the country some leeway and wait for the May numbers to see how well things are bouncing back, but until then, the sheer magnitude of the fallout is frightening. Meanwhile, the push and pull of the bond rally (JPY supportive) and the worry over sovereign debt levels (JPY negative) is seeing plenty of churning in JPY crosses,” Saxo Bank notes.
Just More Trouble
New Zealand’s RBNZ threw the market a surprise in stating that it expected the cash rate level would be “appropriate for some time”, as it noted that the “outlook for the New Zealand economy remains very uncertain following February’s Christchurch earthquake”.
“The market wasn’t particularly well positioned for this and the NZD was weaker across the board – even against the US dollar relative to yesterday’s levels.”
NZD/USD:
“The 80 level is also a psychological barrier for the market. But look how far we have come over the last several weeks – it would take quite some doing to reverse the trend. If 80 fails on the close today, we may have to shift the focus to support a bit further to the south,” John Hardy points out.
Very Ugly and Downright Awful
A significant bite was taken out of the pound’s rally against the USD overnight on the release of a very ugly GfK confidence survey, which showed a strong dip to -31, the lowest level since early 2009.
“The UK is in a very similar boat as the US – though the UK government at least taking a step in the direction of austerity while US politicians are divided on even inconsequential budget moves still seems to be giving sterling a premium. But eventually, a sovereign debt crisis theme could weigh as heavily on the pound as well,” Saxo Bank comments.
Today’s US jobless claims data was downright awful.
“We can always toss the GDP data out the window as yesterday’s news, but the weakness is still remarkable considering the massive support from the FED and from the Obama stimulus that provided a strong tailwind from the turn of the year. But the weekly initial jobless claims number has to make us all uncomfortable with the prospects for the US job market, as this week’s claims are the highest since January and now we have three 400k+ readings in a row,” Hardy writes.
Looking Ahead (Trying)
“As US long treasuries are rallying to new local highs (lows in yield) today in the wake of the weak US data, we have a 7-year US treasury auction that offers another test of demand for treasuries, which still appears rather robust at the moment (a phenomenon that continues to stick out like a sore thumb considering developments in other markets, perhaps reflecting the increasing signs of a weakening in the US economy, not to mention the background excuse of FED buying, though it’s important to remember that treasuries sold off consistently for a long time once QE2 became a reality).”
Yesterday’s 5-year auction saw results in line with recent averages despite the uncertainty of the FOMC proceedings that took place in the auction’s wake.
“Could a strong bond market and a weakening risk appetite today pummel some of the pro-risk JPY crosses? Also – is the ugly US data USD bearish because of an increased likelihood the market prices in of QE3+ or is it USD supportive for a little while considering how far we have already come and due to the potential for some risk aversion?” Hardy writes.
And perhaps the most valuable trading tips of today:
John J. Hardy
John J. Hardy is Consulting FX Strategist for Saxo Bank.
John has developed a broad following from his popular and often quoted daily Forex Market Update column, received by Saxo Bank clients and partners, the press and sales traders.
Read also: Saxo FX Monthly April 2011.
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By the way, here’s Saxo’s latest update on equities:
“The first quarter earnings season continues in a strong way – with 224 S&P 500 companies having reported so far and 77% of these having surprised to the upside. Peter Garnry, Equity Strategist, Saxo Bank takes a look at some of the strong performers across a few sectors. He discusses the earnings from Amazon and UPS, which are both benefiting from more consumers buying products on line, plus European banks which are now well into their quarterly reporting but are struggling more than their U.S. counterparts. He also comments on automakers like Ford Motor which reported its best earnings since 1998 and a possible sales boost for U.S. and European car makers collectively due to the post earthquake production and supply struggles of their Japanese competitors. Volvo is also mentioned in terms of an emerging heavy vehcile replacement cycle.”
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