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Archive for the ‘Debt Crisis’ Category

No More Prevarication on Public Debt

PAUL KRUGMAN, the Nobel Prize winning economist, was in top thundering form in his comments on the recent meeting of G-20 finance ministers, which – apparently prompted by the new coalition government in the UK – produced a noticeable change in political rhetoric by welcoming the plans by several countries to start tackling their hefty budget deficits.

“It’s basically incredible that this is happening with unemployment in the euro area still rising, and only slight labor market progress in the US” says Krugman.  Bowing to demands from the financial markets for fiscal austerity, in his view, is “utter folly posing as wisdom”.

“Don’t we need to worry about government debt?” he goes on. “Yes — but slashing spending while the economy is still deeply depressed is both an extremely costly and quite ineffective way to reduce future debt”. The right thing would be to wait until after the economy is strong enough to allow monetary policy to offset fiscal austerity. “But no: the deficit hawks want their cuts while unemployment rates are still at near-record highs and monetary policy is still hard up against the zero bound”.

The intellectual credentials of Prof Krugman are scarcely in question. But is he right to warn that even starting to tackle the fiscal imbalances today dooms us to another recession, or even depression? Without getting into a futile doctrinal debate between followers of Keynes and the Austrian school of economists, the alternative view, much more popular in the circles which I frequent, is that tackling debt with yet more debt is a far surer way to long term ruin. Postponing the evil day, after all, was at the heart of the Federal Reserve’s failings in the later years of Alan Greenspan’s tenure and helped to land us where we are today.

Not even to begin laying the ground for reductions in public spending today, let alone to confront the huge unfunded liabilities that lie beyond budget planning horizons, makes little sense. On past form it will take years for any cuts announced today to be fully implemented, if indeed they can be achieved at all. Just as 364 economists turned out to be wrong when they denounced Sir Geoffrey Howe’s infamous 1981 UK budget, it is not axiomatic to me that Prof Krugman and co are right this time round.

In any event it is surely debatable to blame the imminence of spending cuts mainly on pressure from the financial markets. It is not, after all, as if the “bond market vigilantes” have been much in evidence recently. Long term bond yields have been falling, not rising – foolishly, history may yet judge. Pointing out the inconvenient fact that Greece and other countries have unsustainable fiscal problems is meanwhile hardly an insight confined to a few hedge fund managers.

What really seems to affront the liberal academic mind is the idea that financial markets – irrational, greedy and capricious as they indubitably can be at times – should be seen to be driving public policy in any way. Unfortunately, a good deal of the argument about fiscal consolidation is about the timing of economic recovery, the appetite for risk in the private sector and the second and third order effects of fiscal tightening. This kind of judgment, in my experience, has never been the forte of economists, whatever their school.

Unsurprisingly perhaps, I take more comfort from Paul Volcker, who as a former Chairman of the Federal Reserve has a gold-plated track record in dealing with the consequences of past financial excess (and was rightly lauded by Prof Krugman, among others, for that achievement). In an excellent recent article in the New York Review of Books, after discussing his plans for banking reform, Mr Volcker observes: “The critical policy issues we face go way beyond the technicalities of law and regulation of financial markets”.

“If we need any further illustration of the potential threats to our own economy from uncontrolled borrowing, we have only to look to the struggle to maintain the common European currency, to rebalance the European economy, and to sustain the political cohesion of Europe. Amounts approaching a trillion dollars have been marshaled from national and international resources to deal with those challenges. Financing can buy time, but not indefinite time. The underlying hard fiscal and economic adjustments are necessary”. 

That sentiment is surely unquestionable. It is only recently however that political rhetoric across the indebted developed world is starting to match up to the scale of the challenge; and even then, it has to be said, the degree of realism that is on public display is often all too closely tied to the imminence of elections. President Obama’s intemperate attack on BP for its failings in the Gulf of Mexico shows that the syndrome is as true in Washington as it is in London, Frankfurt and Athens.

“As we look to that European experience” says Volcker “let’s consider our own situation. We are not a small country highly vulnerable to speculative attack. In an uncertain world, our currency and credit are well established. But there are serious questions, most immediately about the sustainability of our commitment to growing entitlement programs. Looking only a little further ahead, there are even larger questions of critical importance for those of less advanced age than I. The need to achieve a consensus for effective action against global warming, for energy independence, and for protecting the environment is not going to go away. Are we really prepared to meet those problems, and the related fiscal implications? If not, today’s concerns may soon become tomorrow’s existential crises”.

Mr Volcker also draws on a recent visit to Ireland to justify his view that optimism is not entirely out of place in this critical environment for policymakers. “It’s a small country, with few resources and, to put it mildly, a troubled history. In the last twenty years, it took a great leap forward, escaping from its economic lethargy and its internal conflicts. Responding to the potential of free and open markets and the stable European currency, standards of living have bounded higher, close to the general European level. Instead of emigration, there has been an influx of workers from abroad”.

“But now Ireland has been caught up in its own speculative excesses and financial deficits, culminating in a sharp economic decline. There is a lot of grumbling, about banks in particular. But I came away with another impression. The people I spoke to had an understanding that the boom had gotten out of hand. There seems to me a determination to do something about the situation, reflected not just in the words of the political leaders but in support for action among the public. And there is a sense of what is at stake, that the gains they made in recent years have been placed in jeopardy. The urgent need to get back on a sustainable budgetary and economic track is well understood”.

Not so, of course, in the United States. “Restoring our fiscal position, dealing with Social Security and health care obligations in a responsible way, sorting out a reasonable approach toward limiting carbon omissions, and producing domestic energy without unacceptable environmental risks all take time. We’d better get started. That will require a greater sense of common purpose and political consensus than has been evident in Washington or the country at large”.

There is no doubt that the hand of history is sitting heavily on the shoulders of the current generation of political leaders. They have critical judgments to make, and insufficient evidence to be sure that their decisions will turn out right. Mistakes are inevitable. The markets certainly have no monopoly on wisdom either – just look at their apparent readiness to lump in Hungary, a paragon of virtue in fiscal terms, with Greece. But the time for procrastination, as Mr Volcker is right to observe, is passing.

Written by Jonathan Davis

June 14, 2010 at 1:24 PM

Sterling and Equities

By opting out of the euro the UK has saved itself the travails of a Greece or a Spain, which looks like being next in line to feel the full force of the markets’ assault on over-indebted countries. Yet as Dahval Joshi of RAB Capital points out in his latest market commentary, by taking the strain through its currency the UK’s investors are not immune from important shifts in global investors’ attitudes.

This chart from Dahval’s report shows the close correlation between the movement of the London equity market and the value of sterling against the dollar. For the last five years it has been a more or less perfect fit, even though there has been a slight deviation from trend in the last few weeks.


The globalisation of financial markets has of course been a big factor behind the growing dependence on foreign investors’ views. Twenty years ago, foreign ownership accounted for little more than 10% of either the US or the UK stock market. Today the foreign holding of the US equity market has doubled to 25%, while foreign ownership of the UK equity market has actually quadrupled  to 46%. Big moves into or out of equities have necessarily meant foreigners buying or selling large quantities of pounds.

“Another way to explain the impact of equity flows on sterling” Dahval notes “is to look at the equity market capitalisation to GDP ratio of the UK compared to other major economies. The market capitalisation measures the total value of the equity market, but the amount of domestic savings that are available for investment tends to grow in proportion with GDP. So the greater the market cap to GDP ratio, the greater the dependence on foreign investors. And the UK’s ratio, currently 1.2, has been structurally much higher than other major economies such as the US (0.85), Japan (0.65), Eurozone (0.45), or China (0.4). This explains why the pound is highly vulnerable whenever the equity market sells off”.

Just as pertinent is the fact that more than 50% of UK corporate and Government bonds are now owned outside the UK, roughly twice the ratio that holds in the United States, which means that sterling could be additionally vulnerable if the UK’s perceived debt dependence prompts an adverse reaction in the markets. Devaluation has always been the UK’s stock policy reaction to economic difficulties, but investors are increasingly dependent on foreign investor sentiment. Being out of the euro is a blessing, but that does not remove the need for tough measures to correct the looming fiscal crisis in this country.

Written by Jonathan Davis

February 23, 2010 at 1:09 PM

Is the USA going to go the way of Greece?

It has always been said that you can tell the quality of a newspaper by the calibre of its letters page, and on that score the Financial Times has recently once again become a must read, in my opinion. By way of example take the magisterial putdown today by City economist George Magnus of the FT’s illustrious contributor Prof Niall Ferguson, the financial historian. 

In his piece, Prof Ferguson had issued an apocalyptic warning about the likely impact on the United States of its spiralling debt burden. Here is an extract:

“For the world’s biggest economy, the US, the day of reckoning still seems reassuringly remote. The worse things get in the eurozone, the more the US dollar rallies as nervous investors park their cash in the “safe haven” of American government debt. This effect may persist for some months, just as the dollar and Treasuries rallied in the depths of the banking panic in late 2008”.

“Yet even a casual look at the fiscal position of the federal government (not to mention the states) makes a nonsense of the phrase “safe haven”. US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941. Even according to the White House’s new budget projections, the gross federal debt in public hands will exceed 100 per cent of GDP in just two years’ time. This year, like last year, the federal deficit will be around 10 per cent of GDP. The long-run projections of the Congressional Budget Office suggest that the US will never again run a balanced budget. That’s right, never”.

“The International Monetary Fund recently published estimates of the fiscal adjustments developed economies would need to make to restore fiscal stability over the decade ahead. Worst were Japan and the UK (a fiscal tightening of 13 per cent of GDP). Then came Ireland, Spain and Greece (9 per cent). And in sixth place? Step forward America, which would need to tighten fiscal policy by 8.8 per cent of GDP to satisfy the IMF”.

“Explosions of public debt hurt economies in the following way, as numerous empirical studies have shown. By raising fears of default and/or currency depreciation ahead of actual inflation, they push up real interest rates. Higher real rates, in turn, act as drag on growth, especially when the private sector is also heavily indebted – as is the case in most western economies, not least the US”.

“Although the US household savings rate has risen since the Great Recession began, it has not risen enough to absorb a trillion dollars of net Treasury issuance a year. Only two things have thus far stood between the US and higher bond yields: purchases of Treasuries (and mortgage-backed securities, which many sellers essentially swapped for Treasuries) by the Federal Reserve and reserve accumulation by the Chinese monetary authorities”.

“But now the Fed is phasing out such purchases and is expected to wind up quantitative easing. Meanwhile, the Chinese have sharply reduced their purchases of Treasuries from around 47 per cent of new issuance in 2006 to 20 per cent in 2008 to an estimated 5 per cent last year. Small wonder Morgan Stanley assumes that 10-year yields will rise from around 3.5 per cent to 5.5 per cent this year. On a gross federal debt fast approaching $1,500bn, that implies up to $300bn of extra interest payments – and you get up there pretty quickly with the average maturity of the debt now below 50 months”.

“Last week Moody’s Investors Service warned that the triple A credit rating of the US should not be taken for granted. That warning recalls Larry Summers’ killer question (posed before he returned to government): “How long can the world’s biggest borrower remain the world’s biggest power?” On reflection, it is appropriate that the fiscal crisis of the west has begun in Greece, the birthplace of western civilization. Soon it will cross the channel to Britain. But the key question is when that crisis will reach the last bastion of western power, on the other side of the Atlantic”.

In his reply George Magnus, for many years at Warburgs, now Senior Economic Adviser at UBS, describes Prof Ferguson’s argument as “surprisingly superficial” and gave four reasons why the US is not in as weak a position as Greece. He said there was “no likelihood that the US will repudiate its debt, and precious little chance that it can default via inflation in the foreseeable future. Prof Ferguson and others who have long expected bond yields to jump because of rising public debt and inflation are in for a very long wait”. He goes on

“The most optimistic, though somewhat delusional, forecasts have money gross domestic product growth returning to about 5 per cent a year over the next five years. That would give some upside risk to current bond yields but not of crisis proportions. The issue then, to follow on from Greece and southern Europe, is whether the bond market can retain credibility over time in US economic and fiscal management, not the size of its debt, per se.

“The US has at least four assets that don’t exist in the eurozone countries. First, it prints the currency in which its liabilities are denominated, and can monetise further, if needs be. Second, it can depreciate its currency. Third, it offers significant and sought after capital market opportunities to its foreign creditors. Fourth, although we have all had crisis-related Big Government thrust upon us, the next years will most likely see US voters balking at European Union and Japanese-type outcomes where social cohesion always trumps structural reform. Further, when Moody’s Investor Services warned recently that the triple-A credit rating could be at risk, it highlighted the reason, less than convincingly, as a possible shortfall in economic growth, not the fiscal position, per se. On this basis, Moody’s could downgrade the entire western world”.

“This is not to make light of the US’s fiscal position, as Prof Ferguson points out, especially because political cohesion and leadership in Washington have gone missing. Rather than the economics of debt management in the US, which are pretty simple and manageable, it is the consequences of political failure and institutional paralysis that we should fear most. That is also the strongest lesson the Atlantic nations should learn from the Mediterranean”.

This is an important argument, and one that should concern long term investors a good deal. On this occasion it seems to me that the City economist clearly has the better of the long view historian – not something that you will often find me thinking. The US has dealt very vigorously with economic crises in the past, and although the debt crisis is a massive one, it is too soon to be sure that this one is too big and too bad to be the exception.

Written by Jonathan Davis

February 12, 2010 at 11:34 PM