How are the OECD countries, Australia, UK, Europe, and North America, going to deal with trillions of dollars of private and government debt amid very long term low or negative interest rates and severe economic stagnation?
Japanese Central Bank is close to monetizing its government’s external debt, essentially the JCB will print money and bail out the Japanese Government. The intergovernmental debts will be canceled or mutually written off in a big accounting consolidation exercise. This will lead to a further depreciation of the yen which has gradually halved since the ‘80s.
Europe would like to emulate Japan but unless there is both political and monetary union this is unlikely to happen. The next best thing is for the EU to have another massive bond bailout and kick the proverbial can down the road. The danger is as EU buys more time, it is giving rise to the ascent of nationalist and fascist fervor as evident in the success of various right-wing parties throughout Europe who are winning the populist votes. This then could lead to the breakup of the Union. Maybe the UK just got out in the nick of time, so as not to be around to be picking up the mess that it knew it will ensue from such a lesion.
The UK having parachuted is reliant on a service economy and net exports to the USA, Net exports of food, pharma, and works of art! Its best chance is to become the next Switzerland with a highly skilled and educated workforce and look for trade deals further afield in the old colonies of Africa, Asia, and even Iran which is a goldmine begging to be explored.
The US prides itself as a reserve trading currency and so its only choice, for now, is to resign itself to a very long period of low or negative interest rates, some restructuring and shedding of ‘zombie companies’ some 15% of the companies on the US stock market. The level of private corporate debt of non-financial US business has reached 50% of GDP and over two-thirds of that is of junk or BBB investment grade. The OECD has alerted its members to the dangerous widening credit spreads as a symptom of irresponsible lending and poor quality of loans a good chunk of which will be maturing in 2020 and 2021 amidst the global pandemic when there is no cash around.
Steam train grinding to a snail's pace
The SARS COVID 2 has brought the financial and economic steam train to a snail’s pace and affected supply chains ahead and it will be a painful task to heat the coal engines and climb out of the inflection curve. There will be a further deepening of the well of fiscal debts and cuts in social spending leading to a dangerous and further layer of the underclass and a police state style control of violence.
The global financial system collapsed in September 2008 at the time when Lehman collapsed which was gouged by the hungry liquidators. There was some stabilization by the fall of 2009 when the G20 and Basil Committee hastily issued several measures to reign in bank lending and derivative exposures to avoid a repeat of 2008 as if this wasn’t obvious before. The progress since 2008 has been painful and disappointingly slow and the IMF recently put out a report not to expect any sort of growth anywhere on the globe and we must get used to long periods of low real and nominal interest rates which are already at historical lows.
The invisible hand
Interest rates and inflation rates are below target. The ECB has a 2% inflation target, but the economy is going backward and even into negative rate territory. The French economy will lose 6 % of its GDP in Q1 2020, this against a net overproduction of 20 Mn barrels of oil even after OPEC + cut back 10M barrels. Even before the COVID 19 outbreak in January 2020, the IMF in its 2016 WEO update, was very pessimistic about economic forecasts. Before that, forecasts had been mysteriously optimistic, and each time been subsequently downgraded which begs the question, is there an invisible hand guiding the forecasters? Well, the cat is truly out of the bag now and some might say, it has run off with the bag!
If we were to examine the levels of private domestic credit of the 35 advanced OECD economies, that is corporates and household debt, we will find that that it has grown to 170% of GDP as compared to 70% in 1980 and 50% just after the second world war. This growth of debt has been taken up, not by productive business, but rather in the form of real estate lending and then a large part of that in existing real estate assets, so no new creation of property either. Property assets are an inelastic supply so fueled by expectant demand, it creates price ramping and a corresponding increase in credit an unearthly upward cycle which continues until optimism is replaced by lack of confidence from which point we begin a rapid downward spiral. Claudio Borio’s work, Head of BIS, shows that this is the sole reason for financial instability and economic crashes. This explains the crash in the ‘80s in Japan, in the ‘90s in Scandinavia and then in 2008 in the US, UK, Spain, and Ireland.
A Moving Target
What we discover is that debt never goes away, it simply migrates to other parts of the economy and also impacts other countries who rely on exports. This phenomenon is evident in the case of Japan, a most advanced economy, during the ‘80s to the ‘90s where heady opulence had replaced traditional frugality with stories of people being served coffee with gold dust, the largest real estate boom ever seen. The Nikkei 225 dived from 39,000 in January 1990 to 18,000 in June 1992. Even though there was cheap credit at zero interest rates on offer, the corporates who were overleveraged, decided to repay their debts eating into their reserves and cut back on investment spending. This behavior continued for two decades which pushed the Japanese economy over the cliff into recession. Public finances took a hammering as tax revenues fell and public expenditure and unemployment costs went up. Thus, the corporate debt simply mutated into the public sector which over the two decades increased from 60% to a whopping 240% of GDP. This was the same pattern for all emerging economies, corporate debt deleveraging followed by recession followed by ballooning fiscal debt.
The most dramatic increase has been in China which was a direct result of deleveraging in US household debt. Chinese debt ballooned from 140% of GDP in 2007 to 200% in 2016. And then China started pouring concrete into making bridges and roads funded by credit. Other emerging economies were also impacted by the deleveraging from private non-financial debt including Thailand, Indonesia, Malaysia, and Singapore where public debt ballooned to compensate for the effect on exports.
The problem with fiscal stimulus financed by debt is akin to an insulin injection to a diabetic, the efficacy wears out very quickly. This is what the G20 did in the Spring of 2009 when they agreed to support a large fiscal deficit with credit. However, once the sugar rush had subsidized, the economies started to worry about how to reduce the deficit and instituted austerity measures and so we ended up in a situation where we learned to accept the worst of both worlds, private debt deleveraging and austerity. The hands of the G20 were firmly tied, they could only go forward with tightening of fiscal policy, and ultra-loose monetary policy with 0% short term interest rates and long-term quantitative easing.
Squeezing the toothpaste
Companies and households already have high debt levels so they are insensitive to quantitative easing. There is a debate on which levers to apply which would have a transmissive effect on the economy. We have mentioned QE already. Other levers are reduction of interest rates to increase asset prices and encourage spending but after discussing Japan’s woes doesn’t this story sound familiar? Such a move would create more inequality and push more people out of homes. Then, how about reducing interest rates to maintain an export competitive economy? This is fine at a country level but just pushes the problem to another country and does nothing for the global economy which is a zero-sum equation. It is a bit like pushing down on one side of a tube of toothpaste with the lid firmly on, nothing will come out of the other end.
Although debt write off and debt restructuring is possible, many believe that this will deepen the recession and just create more debt and so will not work. Those same people argue that we are stuck with this debt forever unless we adopt alternative measures. The solution being proposed is Milton’s and Bernanke’s idea of getting the central banks to print money and give it to the governments to offset tax cuts and expenditure or to monetize existing government bonds. The banks then simply print money and give it to the government to pay off their IOUs. Simple as that. The major banks of the five largest economies are BoE, BoJ, The Fed, ECB, and PBOC Peoples Bank of China.
Consider the recent decision of the Bank of Japan, BoJ. on 16/3/2020, though stopping fiendishly close to monetization, announced monetary easing through the purchase of JGB’s, US dollar liquidity operations through swap line agreements, the taking over of 8 tn Yen of corporate debt (strictly loans against corporate debt), purchase of 2 tn of corporate bonds and just over 12 tn of Yen set aside to buy ETF’s and JREITS. In other words, wholesale nationalization.
So, when the capitalist screws up, the socialists become the Samaritans.
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