Thursday, May 27, 2010

The economy: Little light amid the gloom

A few days ago I posted about the state of the economy. Two recent articles in the British newspaper, the Telegraph, add emphasis to what I said there.

The first talks about the economic situation facing European nations.

Mervyn King, the Bank of England Governor, summed it up best: "Dealing with a banking crisis was difficult enough," he said the other week, "but at least there were public-sector balance sheets on to which the problems could be moved. Once you move into sovereign debt, there is no answer; there's no backstop."

In other words, were this a computer game, the politicians would be down to their last life. Any mistake now and it really is Game Over. Or to pick a slightly more traditional game, it is rather like a session of pass-the-parcel which is fast approaching the end of the line.

The European financial crisis may look and smell rather different to the American banking crisis of a couple of years ago, but strip away the details – the breakdown of the euro, the crumbling of the Spanish banking system to take just two – and what you are left with is the next leg of a global financial crisis. Politicians temporarily "solved" the sub-prime crisis of 2007 and 2008 by nationalising billions of pounds' worth of bank debt. While this helped reinject a little confidence into markets, the real upshot was merely to transfer that debt on to public-sector balance sheets.

. . .

The problem is that this has to stop somewhere, and that gasping noise over the past couple of weeks is the sound of millions of investors realising, all at once, that the music might have stopped. Having leapt back into the market in 2009 and fuelled the biggest stock-market leap since the recovery from the Wall Street Crash in the early 1930s, investors have suddenly deserted. London's FTSE 100 has lost 15 per cent of its value in little more than a month. The mayhem on European bourses is even worse, while on Wall Street the Dow Jones teeters on the brink of the talismanic 10,000 level.

Whatever yardstick you care to choose – share-price moves, the rates at which banks lend to each other, measures of volatility – we are now in a similar position to 2008.

Europe's problem is that the unfortunate game of pass-the-parcel came at just the wrong moment. It resulted in a hefty extra amount of debt being lumped on to its member states' balance sheets when they were least-equipped to deal with it.

Europe was always heading for a crunch. For years, the German and Dutch economies pulled in one direction (high saving, low spending) while the Club Med bloc – Greece, Portugal, Spain, Italy (and their Celtic outpost Ireland) – pulled in the other. At some point, there was always going to be a problem, given that these two economic blocs were yoked together in the same currency, controlled by the same central bank. By triggering the global recession and shovelling an unexpected load of debt on to Greece's balance sheet, the financial crisis has effectively smoked out the European folly.

The Club Med nations – and in many senses Britain – were not so different to sub-prime households: they borrowed cheap in order to raise their standards of living, ignoring the question of whether they could afford to take on so much debt. But, as King points out, sub-prime households – and the banks that lent to them – can usually be bailed out. The International Monetary Fund simply does not have enough cash to bail out a major economy like Spain, Italy or, heaven forfend, Britain. So, again, we find ourselves in unknown territory.

There are plenty of episodes in history when countries have been as indebted as they are now, but they are all associated with periods of war. History shows that when nations reach as high a level of indebtedness as Greece, and have as few prospects of growth, they will almost certainly default. Indeed, the IMF, which has pretty good experience of fiscal crises, privately recommended that Greece restructure its debt (a kind of soft default, renegotiating payment terms). It was refused point-blank by the European authorities.

To understand why, step back for a moment. It is fashionable to compare the current situation to the Lehman Brothers collapse, but that understates its severity. The sub-prime property market in the US, together with its slightly less toxic relatives, represented a $2 trillion mound of debt. The combined public and private debt of the most troubled European countries – Greece, Portugal, Spain and so on – is closer to $9 trillion.

Moreover, whereas the pain from sub-prime was spread out relatively widely, with investors hailing from both sides of the Atlantic, the owners of the suspect European debt tend almost exclusively to be, gulp, Europeans. No one is suggesting all of this debt will go bad, but the European policymakers fear that the merest hint that Greece might default would spark a chain reaction that would cause a more profound crisis than in 2008.

The problem is not merely that holders of Greek government debt would dump their investments, or even that they would ditch their Spanish and Portuguese bonds while they were at it. It is that government debt is the very bedrock of the financial system: should Greek government bonds collapse, the country's banking system would become insolvent overnight. In fact, banks throughout the euro area would be at risk, given that they tend to hold so much of their neighbours' government debt. That, at least, is the theory, but as was the case in the aftermath of Lehman's collapse, no one really knows how great their exposure is.

The other, more cynical, explanation for Brussels' refusal to countenance default is that it fears that this would fatally destabilise the euro project itself – which of course it would. But as the politicians are discovering, organising a European sovereign bail-out is far, far more difficult than rescuing a bank.

There's more at the link.

The second article examines the US money supply, and the implications of its present precipitate decline. (For those interested, Wikipedia has a good article explaining money supply and the various measurements thereof.)

The M3 money supply in the United States is contracting at an accelerating rate that now matches the average decline seen from 1929 to 1933, despite near zero interest rates and the biggest fiscal blitz in history.

The M3 figures - which include broad range of bank accounts and are tracked by British and European monetarists for warning signals about the direction of the US economy a year or so in advance - began shrinking last summer. The pace has since quickened.

The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc. The assets of insitutional money market funds fell at a 37pc rate, the sharpest drop ever.

"It’s frightening," said Professor Tim Congdon from International Monetary Research. "The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly," he said.

The US authorities have an entirely different explanation for the failure of stimulus measures to gain full traction. They are opting instead for yet further doses of Keynesian spending, despite warnings from the IMF that the gross public debt of the US will reach 97pc of GDP next year and 110pc by 2015.

Larry Summers, President Barack Obama’s top economic adviser, has asked Congress to "grit its teeth" and approve a fresh fiscal boost of $200bn to keep growth on track. "We are nearly 8m jobs short of normal employment. For millions of Americans the economic emergency grinds on," he said.

David Rosenberg from Gluskin Sheff said the White House appears to have reversed course just weeks after Mr Obama vowed to rein in a budget deficit of $1.5 trillion (9.4pc of GDP) this year and set up a commission to target cuts. "You truly cannot make this stuff up. The US governnment is freaked out about the prospect of a double-dip," he said.

The White House request is a tacit admission that the economy is already losing thrust and may stall later this year as stimulus from the original $800bn package starts to fade.

. . .

Mr Summers acknowledged in a speech this week that the eurozone crisis had shone a spotlight on the dangers of spiralling public debt. He said deficit spending delays the day of reckoning and leaves the US at the mercy of foreign creditors. Ultimately, "failure begets failure" in fiscal policy as the logic of compound interest does its worst.

. . .

Mr Congdon said the Obama policy risks repeating the strategic errors of Japan, which pushed debt to dangerously high levels with one fiscal boost after another during its Lost Decade, instead of resorting to full-blown "Friedmanite" monetary stimulus.

"Fiscal policy does not work. The US has just tried the biggest fiscal experiment in history and it has failed. What matters is the quantity of money and in extremis that can be increased easily by quantititave easing. If the Fed doesn’t act, a double-dip recession is a virtual certainty," he said.

Mr Congdon said the dominant voices in US policy-making - Nobel laureates Paul Krugman and Joe Stiglitz, as well as Mr Summers and Fed chair Ben Bernanke - are all Keynesians of different stripes who "despise traditional monetary theory and have a religious aversion to any mention of the quantity of money". The great opus by Milton Friedman and Anna Schwartz - The Monetary History of the United States - has been left to gather dust.

Mr Bernanke no longer pays attention to the M3 data. The bank stopped publishing the data five years ago, deeming it too erratic to be of much use.

This may have been a serious error since double-digit growth of M3 during the US housing bubble gave clear warnings that the boom was out of control. The sudden slowdown in M3 in early to mid-2008 - just as the Fed talked of raising rates - gave a second warning that the economy was about to go into a nosedive.

Mr Bernanke built his academic reputation on the study of the credit mechanism. This model offers a radically different theory for how the financial system works. While so-called "creditism" has become the new orthodoxy in US central banking, it has not yet been tested over time and may yet prove to be a misadventure.

Paul Ashworth at Capital Economics said the decline in M3 is worrying and points to a growing risk of deflation. "Core inflation is already the lowest since 1966, so we don’t have much margin for error here. Deflation becomes a threat if it goes on long enough to become entrenched," he said.

Again, there's more at the link.

These articles, and other links I provided in my earlier article, illustrate the ongoing nature of the economic crisis. Indeed, as the Telegraph points out in a third article, the science of economics is itself in crisis, with most so-called 'authorities' in the field caught flat-footed by events.

Don't believe anyone who tells you things are getting better, or are about to do so. There's far too much residue left over from the flawed, failed policies of the past. Most particularly, our politicians (who largely caused the present crisis through their abdication of responsibility and pandering to special interests) simply won't do anything that will address the true causes of the problem, for fear of alienating the voters they depend upon to re-elect them. Far too many of the voters of America will rebel if informed that their welfare and/or Social Security and/or Medicare entitlements will have to be drastically cut back, because there's simply no money available to pay for them. Therefore, the politicians go on letting the problems get worse . . . because most of them (from any and all parties) are spineless jellyfish, pustulent carbuncles on the body politic, who'll do whatever it takes to get re-elected - even if that means allowing the entire US economy to self-destruct.

We're a long way from turning the corner.



THUC said...

Great points; great post.

I remain deeply worried and am trying to deleverage both personally and at work.

...which, of course, because of fractional reserve banking, means that I've helped contract the M3 !

TJIC said...

....uh, that should be username "TJIC".