Alasdair Macleod – 22 December 2009
The last five to ten years has seen an accelerating shift in economic power away from Europe and America to China, south-east Asia, India and Brazil. In the former group this change in trend is exacerbated by increased regulation and restrictions on economic freedom, while the latter is deregulating and has an expanding pool of labour at its disposal.
Anything the West does with the best of intentions makes things worse. The regulatory screw tightens further. Blame for economic failure is directed at the private sector, while the public sector is seen as the means of rescue. At a time when the new kids on the block are discarding socialism, the West is retreating into it. The comfort one gains from any comparison with the Decline and Fall of the Roman Empire misses the speed of change. The Decline and Fall of the West is considerably more rapid, and is accelerating exponentially. In algebraic terms, y=-x^2.
A major cause of this destruction is adherence to Keynesian policies by America, Europe and the UK. Keynesian economics seeks to rescue economic growth by increasing government spending. It cannot work, and will ensure our downfall. By taxing the productive to support the unproductive, ignoring bureaucratic costs there is no loss of money to the private sector; the point Keynesians miss is the loss is of production. The more government spends, the greater the loss. These distortions lead to a result the opposite of that intended. This is the reason for the failure of all command economies.
Less easy to understand for many is the economic destruction wrought by central banks through monetary policy. Holding interest rates at or close to zero discourages savings and encourages speculation. The policy is presumably aimed to encourage debtors to borrow more to finance continued consumption. The debtors are maxed out and instead are paying down their debts, so the policy of zero interest rates makes no contribution to economic recovery. Furthermore, through the mispricing of money and the resulting reduction of the supply of savings there can be no sound basis for economic recovery. Another aim of zero interest rates is to encourage growth in money supply, and it is even failing in that objective. Central banks are having to force money into the system through printing to finance government deficits.
Zero interest rates are not achieving their objectives, but they are creating a serious banking problem. On one side of their balance sheets banks are not renewing loans as they fall due and consequently are lengthening average loan duration. At the same time zero interest rates are discouraging term deposits, because the risk-reward for depositors is obviously wrong. This lethal combination is reducing the ability of banks to survive a run on them, and the FDIC[i] estimates that 20% of US banks now have over half their balance sheets tied up in long-term assets. The longer that interest rates remain at these levels the more illiquid bank balance sheets will become. Remember that the only reason that banks can borrow short and lend long is they retain sufficient liquidity to maintain depositors’ confidence: for an increasing element of both the American and the global banking system this is no longer the case.
An unspoken objective of printing money is the devaluation of long-term obligations. The success of this objective depends entirely on people not noticing this debasement. However, printing money leads to a falling currency and sooner or later, sharply higher interest rates. Now that it is obvious that the old democracies are all but bust, the rating agencies have begun to adjust country ratings, a process which will continue. The weakest of the Mediterranean Economies, starting with Greece, are beginning to suffer from this process, but before dismissing Greece’s misfortune it should be remembered that the US and UK has many financial similarities with it and their budget deficits are actually worse. Perhaps 2010 will be about recognition of the true position of national finances.
Keynesian and monetarist policies will finally fail or have to be abandoned. This will not happen on government initiatives, because to accept these realities involves considerable short-term pain while decades of economic distortions are unwound. That is the background against which economic predictions for 2010 have to be made.
The United States – 2010, the year of the funding crunch
Any discussion of the financial and economic outlook has to start with the United States. With a GDP of $14 trillion it is the largest economy by far, the dollar is the world’s reserve currency, and its few investment banks dominate global finances. Its problems are everyone’s, and America needs to deflate its credit balloon in an orderly manner, a problem being deferred and not addressed.
The US government’s fiscal strategy has been to spend without limit. The budget deficit in 2007 was less than $200bn; in 2009 at $1,587bn it was eight times larger. The rapid expansion of the deficit has perhaps temporarily stabilised job losses from the public sector, with 640,000 jobs saved or created through Recovery Act Contracts[ii]. This is classic Keynesianism. At the same time monetary strategy is to print without limit. Since August 2008 the monetary base has been expanded by 140% (to November 2009), an unprecedented action in modern American history[iii]. The inflationary consequences of this policy have only been delayed, because the banks have allowed their reserves to accumulate at the central bank rather then enter public circulation.
The success or otherwise of US fiscal and monetary policy is crucial to financial and economic outcomes in 2010.
The State and the private sector
The chart[iv] below shows GDP deflated by the CPI (historic and forecast) split into public sector and private sector components.
Splitting GDP growth into public and private sectors exposes how much the private sector is suffering. The headline rate for 2009 looks like a normal recession when an increase in Federal, state and local spending of 12.7% is included, but removing this distortion shows that private sector GDP actually collapsed by 9.5%. The chart also shows how the Congressional Budget Office forecasts a mild recovery in the current fiscal year to September 2010. The theory is that the extra public spending in 2009 and its approximate maintenance in 2010 will stabilise the private sector. This is conventional Keynesian stuff, and there is indeed now a degree of economic stability in the private sector; but some important statistics suggest at best this is weak, and at worst may only be temporary.
The most worrying statistic is the decline in bank lending, with net loans and leases falling by 6.9% in the four quarters ending September 2009. Within this, Commercial and Industrial Loans fell 15.4%, and loans to individuals fell only 3.9%[v]. Not only is bank lending contracting, but the necessary adjustment of loans to consumers has hardly started. In any case, it is impossible for the private sector to resume economic growth without bank lending growing as well. But given that the credit bubble must deflate to more normal levels, a general trend of falling bank lending is to be expected and should continue. The consumer alone owes $17 trillion[vi], or over twice private sector GDP, which gives a sense of the scale of the problem.
The credit bubble arose because the consumer borrowed on the back of rising property prices to pay for excess consumption. Furthermore, only the first wave of property foreclosures has been seen, with an increasing number of adjustable rate mortgages due to reset over the next eighteen months, at a time when interest rates are likely to rise. The consumer is now faced with the long hard slog of paying down mortgage debt to restore his finances.
It is difficult to see how this can be done without widespread defaults, because the American consumer is still in deep crisis. True unemployment is running at over 17% on the U6 broad measure, while including the long-term unemployed and discouraged workers excluded from U6 gives a depression-like figure of over 21%[vii]. This is a bad basis to face the next wave of mortgage resets, most of which were taken out at high loan-to-values at the height of the boom, and so are likely to lead to another wave of massive write-offs for the banks. The consumer’s refuge in times of difficulty is his credit card, and here again, the door is being shut. Banks’ lending through credit cards has been reduced by 12% over the first three quarters of 2009, which taken in conjunction with average interest rates of 13.71% is a substantial repayment burden[viii].
Banks are also struggling against problems in the commercial property market. The LTV is now over 80% on loans of $3.05 trillion, which is backed by total bank equity of only $1.316 trillion. The problem is further compounded by the relatively short terms at loan origination, requiring up to 20% of loans to be rolled over and above the foreclosures.[ix]
It will be deduced from the foregoing, for the government and the Fed to get through 2010 without mishap will require the skill, judgement and luck of Ulysses on his journey from Troy to Ithaca. Assuming Geitner and Bernanke achieve this difficult task we must expect to enter 2011 with less private sector debt than today for the simple reason that consumer debt has to be reduced. The bubble must deflate in an ordered manner.
This “best-case” outcome shows Congressional Budget Office forecasts to be optimistic, as they expect a GDP growth for 2010 of 2.4% but are silent on the subject of consumer debt. Furthermore the CBO ignores the increasing risk of systemic or external financial failure.
The government is not in control
There is a significant risk of a major banking problem developing in 2010. Banks are the ham in the sandwich of depositors and borrowers at a time of debt deflation, which is bound to result in financial dislocation, bankruptcies and business closures. US banks are also exposed to foreign financial institutions as counterparties, so they are also at risk from financial dislocation in other jurisdictions. Furthermore their assets are becoming more long-term for the reasons described above, escalating the risk of bank failures.
Let us suppose that the authorities in the US are on high-alert for signs of systemic failures in the banking system from both home and abroad. The authorities are no longer complacent, presumably have stress-tested possible scenarios and are now wiser; but whether or not this is sufficient only time will tell. However, there are other problems more of the government’s own making and relate to its own finances. In this respect it is time to resuscitate the twin deficits theory and apply the consequences to the sale of government debt.
According to the twin-deficit hypothesis, when a government increases its fiscal deficit—for instance, by reducing taxes or increasing spending—domestic residents use some of the windfall to boost consumption, causing total national (private and public) saving to decline. The decline in saving requires the country either to borrow from abroad or reduce its foreign lending, unless domestic investment decreases enough to offset the saving shortfall. Thus, a wider fiscal deficit typically should be accompanied by a wider current account deficit.
However, we know that the trade deficit is now contracting at a time when the budget deficit is increasing, and this is illustrated in the chart below, which shows how much the trade deficit (blue line) has contracted recently, while the budget deficit (red line – smoothed) has deteriorated significantly.
The relevance is that the trade deficit has led to large pools of dollars being held abroad and reinvested in Treasury securities. But there is now a contracting trade deficit reducing global capital flows. The trade deficit can no longer finance the budget deficit, so how is it to be financed?
In the absence of public spending cuts or increased taxes, the budget deficit can be bridged by increased domestic savings, net capital inflows, from the banking system or by printing money. The amount of capital now required from these sources is enormous, not only because of the unprecedented trade deficit, but also because there is less trade-related capital available. In 2009, the gap was bridged by a mixture of portfolio shifts into risk-averse assets (including shifts in commercial bank lending) and by quantitative easing. This cannot continue indefinitely, so in 2010 how is the budget deficit going to be funded?
The budget deficit for fiscal 2010 is likely to be over $1,500bn[x], and assuming the trend for the trade balance continues, perhaps $1,200bn of the deficit will have to be financed from sources other than trade-related. These are net inflows of foreign capital, the private sector, from the banking system and by inflation[xi]. And this assumes that on balance all the trade-related dollars go to the public sector.
We know that exporting nations and sovereign wealth funds are seeking to diversify from the dollar, so are unlikely to add to their existing exposure. We also know bank lending is contracting, which tells us that individuals and businesses are paying down debt and not saving, so it is probably safe to assume the private sector excluding banks will leave the bulk of this $1,200 gap to be funded by the banking system and through inflationary sources. The simple solution is to tap the banks.
The US commercial banks have the resources to fund the entire deficit, because they have excess reserves of over $1 trillion sitting idle at the Fed, which through fractional reserve banking can be geared up to cover any deficit. Note that so long as these reserves sit at the Fed they are not in circulation. However, drawing down excess reserves and creating credit on the back of it is highly inflationary. While the Fed must be aware of the inflation risk, it has little option but to rely on banks for government funding for at least some of the deficit.
The result will be to unleash the latent inflation from financial rescues of the last eighteen months, since they are the reasons the excess reserves at the Fed now exist. Furthermore, when government spends this created money it will do so inefficiently, so the recipe for inflation becomes a recipe for stagflation. This will undermine the dollar, implying that interest rates will have to rise.
A circular problem develops, since in a rising interest rate environment this is bound to have a negative impact on banks the majority of whose assets pay fixed coupons. The subsequent write-downs could make those of the last eighteen months look like a warm-up act, and will reduce banks’ appetite for yet more Treasuries, making funding the budget deficit even more difficult. At this point, quantitative easing can be ruled out of any solution.
The obvious, if painful answer, is that the US Government has entered a debt trap, and the choice will lie between accelerating inflation or abandoning Keynesian economics and zero interest rate policies. The former is like cocaine, the later is reality.
Your call, Mr President!
The United Kingdom – Election year
The UK is making the same policy mistakes as the Americans. UK banks face the twin banking problem of contracting lending and decreasing asset liquidity on their domestic books, and through London’s role in international capital markets they are exposed to everyone else’s systemic failures. Meanwhile the Bank of England leads the way with quantitative easing, or printing money to fund more or less the entire budget deficit.
The Chancellor is left struggling with a budget deficit of about 13% of GDP for this and the next fiscal year, which equates with that of Greece (12.7% in 2009). Like the US, the UK is relying on private sector growth to reduce this deficit in subsequent years. Like the US, economic salvation from the private sector is unlikely. Indeed the Keynesian concept of covering the private sector slump by growing the public sector shows similarities with the US position as the chart below illustrates.[xii]
The Treasury assumes that growth in 2010/11 will recover to 1-1 ½%, and then 3 ½% in 2011/12. Like its American counterpart, the UK Treasury forecast for fiscal 2010/11 is a comforting return to normal.
Therefore all the core analysis of prospects for the US also applies to the UK. The similarities by far outnumber the differences. The important difference is that a disappointing economic outturn for the UK would have little effect on the US, but a disappointing outturn for the US would lead to serious economic problems for the UK. The UK therefore has less control over its economic future. And the UK does have other problems which are more domestic.
The main political event in 2010 will be a general election. It is assumed by all commentators that whoever is elected will deal with the important economic issues, particularly cutting public spending. This belief is optimistic.
The general assumption is that the next government will have a mandate to tackle serious economic problems, but this certainly cannot apply to a hung parliament or a government with a small majority. It assumes agreement on the correct economic policies when economists themselves are unsure. Crucially, the main economic assumption is that recovery will occur on similar lines to Treasury forecasts.
The political and economic assumptions are therefore contradictory: how will the economy remain steady with the required cuts in public spending? Anyway, it is hard to see how the political climate will accept a reversal of the gradual drift away from the private sector into the arms of government. Not even a government with a clear majority can get round this fact. Times have moved on from the days of Mrs Thatcher, and the UK’s economic problems are at least a whole degree worse.
Whatever the Conservatives’ new economic policies, they will not be able to deliberately bring about the necessary economic reforms. Free markets are no longer in the electorate’s psyche. The fields of Albion are populated with sacred cows, and their slaughter will leave the pastures bare. For change to occur there has to be a crisis sufficient to overturn political views. That is the likely order of things, crisis first and change second; and it will be better for an incoming government if the crisis happens before the election.
Rather than paint a scenario for the pound based on election outcomes, it is safer to assume that all election outcomes will be bad for the pound. This was even true of the early years of Margaret Thatcher when sterling fell from $2.43 to $1.05 between October 1980 and February 1985, a period when her government bravely tackled and overcame many of Britain’s economic ills.
With its disadvantages and uncertainties Britain seems to be relying on foreign investors to fund its deficits while domestic savings are discouraged by close-to-zero interest rates. However, foreign investors have little commercial or portfolio need to hold sterling because sterling is not a reserve currency. From and international perspective the UK scores badly, because the credit bubble has hardly begun to unwind. House prices have fallen little on balance. Cuts in VAT, stamp duty and the car scrappage scheme have bought forward demand for housing and capital goods, helping to keep the bubble inflated. Where the US has been, the UK is yet to go.
So 2010 is shaping up to be a bad year for Britain and sterling. If Greece is rated BBB+, Britain should be as well, and international investors know it. There is no evidence in this election year that the lessons of history will be applied. In 2009, the Labour Government was only able to fund its budget deficit through quantitative easing: in other words it printed its entire deficit. It benefited, as other governments have, from the pause following the banking crisis and the tentative economic recovery.
It is difficult to see how this trick will be repeated in 2010, whoever is in power. The only solution is to cut public expenditure to the bone, reverse the tide of regulation, and allow interest rates to rise to the point where the deficit can be funded, without crowding out private sector borrowing. Unless this is done, the markets will force this solution on Britain, as they have done in years past. This time, Britain is not alone.
Finally, we must spare a thought for all those who as a result of failed government economic policies rather than their own fault are unemployed, broke, hungry and cold over Christmas. Spare a thought for our youth, who have no hope of employment and are an unwilling and continuing burden on their parents. Help them to emigrate to countries with better prospects and lower taxes.
And those of us in Britain should just reflect and sympathise with the millions of Americans who are reliving the Great Depression, if only because we are next.
Happy New Year, and as for 2010, let us hope we are spared.
[i] Federal Insurance Deposit Corporation, Supervisory Insights, Winter 2009.
[iv] Underlying data from http://www.usgovernmentspending.com and the Congressional Budget Office deflated by the CPI.
[vi] Mortgages are $14.5 trillion, and consumer credit $2.5 trillion. See http://www.federalreserve.gov/econresdata/releases/statisticsdata.htm
[vii] See http://www.shadowstats.com/
[ix] See “Household debt and commercial property create banking problems” FinanceAndEconomics 11 November 2009.
[x] The CBO’s forecast of $1,381bn is based on optimistic economic forecasts which are unlikely to be met for the reasons set out in this document. The outturn is therefore likely to be considerably worse, and $1,500bn is a reasonable baseline.
[xi] A substantial element of government funding is reflected in the national accounts as being through various government agencies. I take the view that this is inflationary on the basis that the government is financing its own expenditure without external input, and therefore lump this funding into the general heading of inflationary.
[xii] Underlying data from the Treasury. See “GDP estimates exposed”, FinanceAndEconomics 23 November 2009.