Ponzi Prosperity Built-to-Fail Economic Models
by Satyajit Das
Monday, 06 July 2009 15:33
Lessons from the global financial crisis
The global financial crisis (GFC) is financial, economic, social and
increasingly ideological. French President Nikolas Sarkozy has
pronounced the death of laissez-faire capitalism: "c'est fini." Leaders
have penned fevered attacks on "neo-liberalism." Even religious leaders
have taken to the pulpit to denounce capitalism.
Undoubtedly market failures, management excesses and errors caused the GFC. But the key lessons of the crisis may be subtler than first evident.
Global growth has been driven by cheap and abundant debt, and improperly costed carbon emissions and other forms of pollution. The reality is that this period of growth may be coming to an end.
All brands of politics and economics have been informed by assumptions about the sustainability of high levels of economic growth and the belief that governments and central bankers can exert a substantial degree of control over the economy. Harry Johnson, the famed Chicago economist, writing about England in the 1970s with his wife Elizabeth in "The Shadow of Keynes" (1978), provides a vivid description of this pre-occupation: "faster economic growth is the panacea for all" economic and political problems and "faster growth can be easily achieved by a combination of inflationary demand-management policies and politically appealing fiscal gimmickry."
The current debate misses the point, that it may not be feasible to reattain the growth levels in the global economy of the last 20 or so years.
Goldilocks economy
P.J. O'Rourke, writing in "Eat The Rich" (1998), observed that:
"Economics is an entire scientific discipline of not knowing what you're
talking about." The only quibble may be with the "scientific" part.
Recent global prosperity was founded on a series of elegant Ponzi
schemes.
Consumption rather than investment drove growth, particularly in the
developed world. A deregulated financial system supplied the borrowing
that financed the consumption. In the new economy, to borrow from Earl
Wilson, there were three kinds of people "the haves," "the have-nots,"
and "the have-not-paid-for-what-they-haves."
Growth in global trade was also debt-fueled. Since the 1990s, there has
been a substantial buildup of foreign reserves in central banks of
emerging markets and developing countries that became the foundation for
a trade financing arrangement.
To maintain export competitiveness, many global currencies, including
the Chinese Renminbi, were pegged to the dollar at an artificially low
rate. This helped create the U.S. trade deficit driven by excess U.S.
demand for imports based on an overvalued dollar. Foreign central
bankers invested the dollars received from exports in U.S. debt to
minimize the appreciation of their domestic currency that would make
their exports less competitive. The recycled dollars flowed back to the
U.S. to finance the spending on imports, helping keep U.S. interest
rates low, which facilitated more borrowing to finance further
consumption and imports.
Foreign central banks were lending their reserves to finance exports from the country. In essence, the exporting nations were not paid at least until the loan to the buyer was paid off.
Moderate debt levels are sustainable, provided the value of the asset supporting the borrowing is stable and significantly higher than the amount of the loan. The borrower or the collateral for the loan must generate sufficient income to service and repay the borrowing. In the frenzied market environment of low interest rates and ever-rising asset prices, the level of collateral cover and ability to service the loans deteriorated sharply. In 2005, rising interest rates and a cooling in the U.S. housing market set the stage for the GFC.
Taking the cure
There is currently confusion between the "disease" the high levels
of debt and the "cure" the reduction of the level of debt now
underway (known as "de-leveraging").
Debt within the financial system is falling as some borrowers default, triggering problems for financial institutions, destroying both existing debt and also limiting the capacity for further credit creation by financial institutions. Total losses from the GFC are estimated by the International Monetary Fund at around $4.1 trillion of which $2.7 trillion will be borne by financial institutions.
Government ownership or de facto nationalization has become the primary option to recapitalize the banking system in many countries. Even after recapitalization, there is likely to be a capital shortfall in the global banking system (of around $ 1+ trillion), forcing a contraction in global credit of around 20% to 30% from existing levels, which affects the real economy.
The increased cost and reduced availability of debt to borrowers forces corporations to reduce leverage by cutting costs, selling assets, reducing investment and raising equity. This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.
Recent excitement about the "stress tests" of U.S. banks misses an essential point. At best if you accept the premises of the test, the risk of failure of these institutions is much reduced. But the banks' ability to support lending levels that prevailed in say 2007 has not been restored. In short, the "credit crunch" or shortage of borrowing will continue for a prolonged period.
This combination of factors may lock the global economy into a cycle of
low growth, bringing an end to the age of Ponzi prosperity.
Sigmund Freud once remarked that: "Illusions commend themselves to us
because they save us pain and allow us to enjoy pleasure instead. We
must therefore accept it without complaint when they sometimes collide
with a bit of reality against which they are dashed to pieces." The GFC
was the "reality" on which the artificial pleasures of the Great
Moderation and Goldilocks economy were smashed.
Socialist WIT
National and international "committees to save the world" have
rushed to announce and occasionally even implement a bewildering and
constantly changing array of measures dubbed WIT ("What it takes") by
British Prime Minister Gordon Brown to counteract the financial and
economic effects of the GFC.
Governments and central banks have sought to remove toxic securities
from bank balance sheets and supply share capital to cover losses from
bad debts. In some countries, such as Australia, the government has
guaranteed the bank's own borrowings to allow them to continue to raise
funding. Bank of England Governor Mervyn King summed up the nature of
the UK's support for the banking system with a Freudian slip: "The
package of measures announced yesterday by the Chancellor are not
designed to protect the banks as such. They are designed to protect the
economy from the banks."
Governments have gone into massive deficit providing fiscal stimulus and support for the housing market (in the U.S.). Central banks have cut interest rates to levels not seen for decades. It seems "we are all Keynesians again."
Fiscal pretensions
The success of these actions is not assured. John Kenneth Galbraith
once observed: "In economics, hope and faith coexist with great
scientific pretension."
Credit conditions have not eased significantly. Money supplied to banks is not flowing into the real economy. Governments and central bankers, frustrated at the failure of policy actions to help the resumption of normal financial activity, have started to lend directly to business or drifted towards "directed lending" policies in an effort to get the economy going.
The policies miss the point that debtors still have too much debt that they are not able to service. Until the debt is written down and restructured, credit growth may not resume.
In the Trouble Asset Relief Program (TARP) Oversight Panel Report of April 8, Professor Elizabeth Warren observed: "Six months into the existence of TARP, evidence of success or failure is mixed. One key assumption that underlies Treasury's approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from non-functioning markets for troubled assets. On the other hand, it is possible that Treasury's approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth."
Well-intentioned government spending programs, such as infrastructure spending, will take time to have any meaningful effect. The return on poorly costed and targeted infrastructure investment is also not necessarily high. If this were otherwise, then Japan, which has concreted the country over several times, would have much higher rates of growth than it does.
Governments, some with significant budget deficits and also substantial levels of outstanding public debt, must also borrow to finance their spending. In 2009, governments around the world will have to issue $3 trillion to $4 trillion in debt.
The U.S. alone will need to issue around $2 trillion in bonds. China,
Japan, Europe and other emerging countries have been major buyer of this
U.S. debt. Wen Jiabao, China's prime minister, provided a reminder of
this in February 2009: "Whether China will continue to buy, and how much
to buy, should be in accordance with China's needs, and depend on the
safety and protection of value of foreign exchange." Yu Yongding, a
former adviser to the Chinese central bank, recently sought guarantees
that the value of China's large holdings of U.S. government debt won't
be eroded by "reckless policies." The U.S., he stated, "should make the
Chinese feel confident that the value of the assets at least will not be
eroded in a significant way."
In 2009, some German bund (government bond) auctions failed with
insufficient bids to cover the amount of issues. One U.K. gilt auction
and more recently, a U.S. 30-year bond auction encountered significant
difficulty and lack of investor support.
At best, the government debt may crowd out other borrowers exacerbating existing financing problems. At worst, there is a risk of a collapse of the growing "bubble" in government debt markets as investors refuse to purchase debt at current rates triggering additional losses.
Since January 2009, long-term interest rates throughout the world have moved up sharply as markets start to absorb the import of government initiatives. As James Carville, Bill Clinton's campaign manager, once noted: "I want to come back as the bond market. You can intimidate everybody."
Hair-of-the-dog cures
The current strategy is a variant of the "hair of the dog that bit
you" cure. Current problems can be traced to high levels of debt
accumulated by banks, consumers and companies that is now being replaced
by government debt. Debt-fueled consumption of consumers and companies
is being replaced by debt-funded government expenditure.
The ineffectiveness of repeated fiscal shock therapy to rouse the Japanese economy from it somnolent state provides a worrying precedent for current policy.
Government actions seem primarily to be based on the recognition that Ponzi or pyramid games are only bad if they end. All efforts are now seemingly directed at keeping the game going for as long as possible!
Governments and central banks can smooth the transition but they cannot prevent the necessary adjustments taking place. In 1976, British Prime Minister James Callaghan delivered the following grim assessment of Britain's economic situation that is still relevant today: "We have been living on borrowed time. We used to think you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candor that that option no longer exists." That warning is as relevant today as it was some 30 years ago.
Built to fail
The key lesson of the GFC may be that the current economic order is
"built to fail." The ability to sustain high rates of economic growth,
required by governments and central bankers, is questionable.
Aggressive use of debt globally resulted in a sharp increase in sustainable growth rates. Four dollars to $5 of debt was required to create $1 of growth. Approximately half the recorded growth in the U.S. over recent years was driven by borrowing against the rising value of houses (mortgage equity withdrawals). A similar pattern is evident in Great Britain and Australia. As the level of debt in the global economy decreases, attainable growth levels also decline.
Debt allowed consumption to be accelerated. Spending that would have taken place normally over a period of many years was squeezed into a relatively short period because of the availability of cheap borrowings. Misreading demand and assuming that the exaggerated growth would continue indefinitely, businesses over-invested, creating significant over-capacity in many sectors. For example, the global car industry has production capacity of over 90 million units compared to peak demand of around 60 million that has now fallen to 40 million.
The nouveau Jeffersonian trinity "whoever dies with the most toys wins;" "shop till you drop;" and "if it feels good, do it" has proved to be unsustainable.
Global trade, on which Australia is heavily dependent, was also "built to fail." A model where sellers of goods and services indirectly financed the purchase is not sustainable.
The GFC has already reduced global trade and cross-border capital flows. Global trade is forecast to fall for the first time in 2009. The Institute for International Finance forecasts net private sector capital flows to emerging markets in 2009 will be less than $165 billion 36% of the $466 billion inflow in 2008 and only one-fifth the record amount in 2007. Many emerging market nations, such as India, face severe funding difficulties in the near future.
In an essay titled "The Great Slump of 1930," published in December of that year, Keynes observed: "We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand."
Policy helplessness
Governments have limited available tools to address the deep-rooted
problems in the current economic models.
Given that interest rates are now at or approaching zero in many
developed countries, there is little or no scope for further monetary
action although central banks have creatively embarked on a program of
"quantitative easing" code for printing money (also know as the Weimar
or Zimbabwe solution).
Government spending, if it can be financed, may not be able to adequately compensate for the contraction of consumption and lack of investment made worse by over capacity in many industries. Government spending has little multiplier effect or velocity. The badly damaged financial system means that the circulation of money in the economy is at a standstill. Government spending provides a short-term demand boost. Capital injections may partially rehabilitate banks. But it is far from clear what will happen when all these measures are reversed.
David Rosenberg, an economist from Merrill Lynch, described the process of adjustment that world is embarking on in the following terms: "This is an epic event; we're talking about the end of a 20-year secular credit expansion that went absolutely parabolic from 2001-2007. Before the U.S. economy can truly begin to expand again, the savings rate must rise to pre-bubble levels of 8%, the U.S. housing stock must fall to below eight-months' supply, and the household interest coverage ratio must fall from 14% to 10.5%. It's important to note what sort of surgery that is going to require. We will probably have to eliminate $2 trillion of household debt to get there, this will happen either through debt being written off, as major financial institutions continue to do, or for consumers themselves to shrink their own balance sheets."
The economic model itself is now seen as the problem. Zhou Xiaochuan, governor of the Chinese central bank, commented: "Over-consumption and a high reliance on credit is the cause of the U.S. financial crisis. As the largest and most important economy in the world, the U.S. should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits."
More ominously, Chinese President Hu Jintao recently noted: "From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies."
The GFC also marks the end of unquestioned advocacy of free markets. Wang Qishan, China's vice premier, tartly observed: "The teachers now have some problems.''
Limits to growth
The GFC coincides with another crisis: the GEC or Global
Environmental Crisis. "Toxic debt" and "toxic emissions" increasingly
clamor simultaneously for politician's attention.
Irreversible climate change, scarcity of vital resources (food and water) and falling biodiversity are not unconnected with the existing economic system. Economists and politicians implicitly assume that high levels of growth drive increased living standards, rescuing people from poverty and social development. No limit to economic growth is recognized.
The GFC brings into question much of established orthodoxy of economic models and approaches. It calls into question social and political models based on high levels of economic growth and financial rather than real economy driven growth. It also questions the ability of mandarins to control the economic engines. The world needs to adjust to a new economic order and a world of reduced expectations.
As Keynes wrote in 1933: "We have reached a critical point. We can ... see clearly the gulf to which our present path is leading .[If governments did not take action], we must expect the progressive breakdown of the existing structure of contract and instruments of indebtedness, accompanied by the utter discredit of orthodox leadership in finance and government, with what ultimate outcome we cannot predict."
Satyajit Das is a risk consultant and author of "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives" (2006, FT-Prentice Hall).
Views are as of July 6, 2009, and are subject to change based on market conditions and other factors. These views, which draw on ideas Das first published in The Monthly magazine (April 8-13, 2009) and the Australian daily newspaper The Age (May 16, 23 and 30, 2009), should not be construed as a recommendation for any specific security.
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