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Big trouble ahead

Written By: - Date published: 10:14 am, August 24th, 2011 - 20 comments
Categories: Economy - Tags: ,

It’s interesting to watch the economists flip as the economic system implodes. The most dramatic (and welcome!) NZ example has been Bernard Hickey but many of his colleagues are also throwing off their neoliberal blinkers. In the post below, a former NZ Reserve Bank adviser explains why the world economy is mired in crisis and why it won’t just fix itself.

Terry McFadgen hasn’t got the whole way there yet. He needs to read theoildrum.com and other oil experts because he misses the fundamental cause – resource limits, most notably oil – which means the ‘solutions’ he proposes won’t work. But the story he tells of how the financial construct we have built on top of those natural resource constraints is coming apart is enlightening, and sobering.

(yes, it annoys me that he refers to himself in the third person too)

– Eddie

————————————————–

Big trouble ahead

Macca was struck by a short piece in a newspaper last weekend titled “Pessimism is The New Black”. The theme was that the wave of pessimism hitting global markets was a bit like a fashion trend: no real rationale, just an inexplicable thing of the moment that would soon morph into something more congenial.

Sadly that is not the case. The underlying structural weaknesses that are roiling markets aren’t a fashion and they are not going to go away any time soon. Here’s a more sober assessment from the guy who is probably the highest paid fund manger in the world (Mo El Erian, CEO at PIMCO, formerly manager of Harvard’s $30b plus endowment):

“The world economy is now in the grips of a damaging feedback loop involving deteriorating fundamentals, lagging policy responses and destabilized financial markets. If policymakers do not act boldly, and do so in a globally coordinated fashion, the world risks slipping into a prolonged recession with worrisome institutional, political and social consequences”.[1]

As befits a former IMF economist, he minces his words. Unless something changes quite dramatically there will surely not be any bold, globally coordinated action and a prolonged global recession or near recession will follow this failure. That is now Macca’s central case.

What’s gone wrong?

Just about everything:

  • US growth data has been ugly. First and second quarter growth looked quite promising but data revisions have pulled that back and for the last six months growth has averaged a little less than 1% annualized. At this level no new jobs can be created and the 15m odd Americans looking for work will grow in number as new entrants join the workforce. Worse still, the American economy is going to have to cope with a fiscal contraction next year of about 2% of GDP as stimulus measures like payroll tax relief expire this December. A recession or near recession in the USA is pretty much guaranteed for 2012 in the absence of a new cross party stimulus deal. The media will focus on the “R” word-but it’s irrelevant whether growth is slightly negative or slightly positive. The USA needs strong growth to escape its current predicament and that is just not going to happen next year.
  •  US house prices continue to weaken a little and the 25% or so of households under water are running out of air. These families cannot move location even if they could find jobs elsewhere. The world’s largest economy is facing a future in which high unemployment will become structural as skills fade and motivation is destroyed. The social consequences- alluded to in passing by El Erian in the paragraph above but of huge importance- will potentially be nasty. The UK riots are a warm up.
  • The US debt ceiling shambles has destroyed investor and business confidence in the ability of the US political elite to manage the country sensibly. Don’t expect businesses to invest or start hiring in this climate. Would you? Sadly, business is the one sector that has cash ready to spend given that households and the Government sector are both in lockdown mode. The best lifeline for the US economy has now been cut by inane political games. As I write, US 10 year Treasury yields have hit their lowest level in 60 years.
  • The European Monetary Union is a shambles, and a debt -death spiral (where rising interest rates force austerity measures which cut tax revenues which  results in expanding fiscal deficits which pushes up rates once more) now threatens economies of real size and importance-Spain, Italy and France. They have responded with panic measures designed to cut fiscal deficits in the hope that bond markets will remain open at attractive rates. But as they all do the fiscal squeeze together, European demand is going to contract. Europe needs growth, not panic driven austerity. This week’s GDP data for the E.U was terrible and the Union now stands on the edge of a recession.
  • A partial break up of the Euro-zone is now Macca’s central case. This sees the weakest of the Club Med members being forced out (Greece and Portugal-maybe Ireland or even Italy) or the rich north (Germany, the Benelux countries, Austria and Finland) cutting themselves loose. It is a case of “choose your poison”. If the weak are forced out, a lot of German and French banks are going to have to be recapitalized to cope with the consequent write- downs in the value of bond holdings. If the rich north departs, then their new currency will appreciate rapidly and the north will end up in recession, at least for a period, as its exports get hammered.
  • Which takes us to China where inflation continues to rage out of control and no meaningful progress has been made towards a rebalancing of the economy away from building”bridges to nowhere”.  Growth in household consumption remains non-existent thanks to policy inertia in relation to wages(suppressed), interest rates on savings(negative real rates), and social safety net initiatives(nil).The best analysis Macca has seen suggests that China GDP needs to fall by about half (i.e. to around 5% pa) to bring inflation under control. Watch out Australia under such a scenario.

All this wouldn’t be quite so frightening if there were visible solutions. But there are not.

Three overriding problems block the view of happier days:

1) Further fiscal stimulus to support the world economy over its looming slump looks a very remote prospect. Most government balance sheets are now fully extended and those that still have capacity to make a difference to the world outlook (the USA, Germany, China) face high political barriers or other constraints.

2) The break up of the Euro-Zone now seems the most likely scenario and, as noted above this only offers lose/lose outcomes the scale of which is uncertain but surely very large.

3) Increasingly, the focus of investors and policymakers is turning to the underlying problem which is that the world faces a shortage of final demand. This is structural, not cyclical[2]. Successive attempts since 2000 to reflate economies with “money dumps” have failed. The latest round of QE dollars simply went into asset speculation or bank reserves. Commodity prices rose (including oil which ironically bit the hand that fed it), and so did stocks. The real economy did nothing. No new lending, no new jobs, no signs of life. The Fed may still be forced into QE3-but they will not do so with any conviction that the real economy will respond in the short term. The objective will be inflation and further USD devaluation (upon which I comment below.)

So the big picture is that of a shrinking or static world economy, a developed world with no gunpowder left in the fiscal or monetary magazines and deep structural issues which remain unresolved. Professor Joseph Stiglitz recently summarized all this as follows:

All of this [gridlock politics in the USA, excessive austerity in Europe] makes it likely the North Atlantic will enter a double dip, but there is nothing magic about the number zero. The critical growth rate is that which stops the jobs deficit getting larger. Problematically, America’s and Europe’s current growth rate of about 1% is less than half the amount required to do this.

When the recession began there were many wise words about having learnt the lessons of both the Great Depression and Japans long malaise. Now we know that we didn’t learn a thing. Our stimulus was too weak, too short and not well designed. The banks weren’t forced to return to lending. Our leaders tried papering over the economy’s weaknesses – perhaps out of fear that if we were honest about them already fragile confidence would erode. But that was a gamble we have now lost.

Now the scale of the problem is apparent, a new confidence has emerged: confidence that matters will get worse, whatever action we take. A long malaise now seems like the optimistic scenario”[3]

Pause for stiff drink here if you wish. Indeed Macca himself had to do so.

How all this will resolve itself is unclear. But three decisions are going to be critical:

  1. Will Germany Fold its Cards and Guarantee all the Bills?
  2. Will The Fed Inflate US Debt Away?
  3. Can A Grand Bargain Be Struck?

1. Germany’s Big Decision

The crisis in the Euro-zone could be solved overnight by Germany guaranteeing the rest of its members either by permitting the issue of Eurobonds backed by the EU as a whole (jointly and severally), or by greatly expanding the EU Emergency Support Fund. Germany’s credit is vast and unquestioned.

But the obstacles are many. For a start ,Germany would not even contemplate such a move without having a high level of permanent control over the budgets of all EU members-a perfectly reasonable requirement. (Would you dear reader want to be guaranteeing Berlusconi or the serial fiscal criminals in Greece, or for that matter the Spaniards with youth unemployment at 40%?).

How would such control be exerted in institutional terms? Does Germany really want that responsibility and how could the transfer of sovereignty possibly be sold to the rest of the EZ populace? The institutions are not in place to take such control, nor does the EZ populace understand the issues. Treaty amendments would be required as a minimum, and probably referenda. In 10-20 years that might be attainable-but today it seems a massive stretch, even under the threat of immediate insolvency in the Club Med.

But the alternative – a break up of the EZ – seems equally unpalatable. Unfortunately it is the default option and the smart money is backing it.

Maybe when we reach one minute to midnight Germany will blink and it will take control of Europe in exchange for its balance sheet. It’s an horrific decision for the German people. My guess – I stress guess – is Germany will not do so because the institutional and constitutional issues are too intractable. So the EZ will struggle on, hoping vainly for a change of market sentiment until it collapses some time next year. What then happens to the wider EU project is very unclear.

Macca wishes it were otherwise because the Euro has been a magnificent – albeit flawed-experiment and the social and political consequences of break up will be with us for decades. Let me offer some final words on this subject from Jeremy Warner, The Daily Telegraph’s economics writer:

“Watching Angela Merkel and Nicholas Sarkozy at their press conference on Tuesday [August23], it was clear that the two are still a million miles away from recognizing the enormity of the choices their nations face-and that the crisis will have to escalate at least a couple of notches before they will even consider the solutions that are required…

The truth is that a project meant to tame Germany and integrate her into the heart of Europe has backfired spectacularly. Far from making economies converge, it has succeeded only in driving them ever apart. From Britain’s island haven, we can only look on in horror as Europe once again stares into the abyss”[4]

British hubris aside, it is hard to disagree.

2. Will The Fed Inflate US Debt Away?

Unlike most other central banks, the Federal Reserve has a dual mandate-to maximize employment and to control inflation. The inflation target has never been formally stated, but like most central banks we can assume it is under but very close to 2% pa.

As long as around 25% of US households with mortgages are under water there will be no employment growth and deflation will be a constant threat. The household mortgage problem could (and should) be solved by fiscal initiatives (e.g. debt for equity swaps offered by the Federal Government), but these routes are almost certainly closed by Washington’s political paralysis.

So what should the Federal Reserve do to meet its mandate? Arguably it should (indeed must) encourage a period of above target inflation. Assume a household with a debt to house value ratio of 100%. Assume also inflation of 4.5% pa for five years. Assisted a little by the power of compounding, the ratio has improved to 80% by year five which is starting to look much more manageable. Household consumption is revived, employment grows, problem solved.

In reality such an approach would involve a massive value transfer from savers (whose savings are devalued) to borrowers (whose debts are being massaged down). The victims of this transfer would be a mixed bunch. Boomers would suffer but so would the Chinese, Japanese and Petro-zone countries all of whom are major lenders to the USA. The USD would be hammered and US yields would come under upwards pressure in the absence of massive QE to force them down.

But massive QE would be required anyway to get inflation going at a good clip. So stand by for QE3-probably after the joint congressional committee has reported on its savings proposal and there is nothing in it for homeowner relief or to ward off a 2012 recession.

Markets therefore see a high risk of US inflation/devaluation and it is not for nothing that the price of gold has doubled in a couple of years, or that the Swiss Franc has gone through the roof in the last month or so.

Apart from the destabilsation of economies outside the USA via currency appreciations (not our issue says the Fed), the major problem is calibration. What additional quantity of money dumped into the financial system is sufficient to get a reasonable amount of inflation but not an avalanche? The Fed will have models which point to answers – but the models are highly uncertain. Risks abound.

The politics too is likely to be fearsome. Savers get hit and over- borrowed households get a free kick. It’s election year and a political fiasco is in prospect which would see the Fed getting dragged into the political arena. Add to that prospect a geopolitical backlash as the value of Chinese US bond holdings is trashed.

Maybe you are now thinking that gold at $2000 per once is not silly and a little place in Bluff (the remotest place on earth for those not familiar with NZ geography) might be a good idea? The rush is on for inflation proof assets but there are not many places to hide. It’s scary.

So will they do it? In my view yes-unless Washington can come up with a fiscal package to head them off, which seems highly unlikely. Stand by for QE3, inflation and further USD weakness.


3. Can A Grand Bargain Be Struck?

As long as global final demand is weak the world economy will remain mired in recession. The global”business model” of the last decade and a half was built on fast growth of household demand in the developed world fuelled by easy credit, Chinese deflation and inflating asset values, particularly housing. That model is now dead. Note that an intrinsic part of the dead system was the build up of massive current account surpluses by China and Germany in particular as they suppressed domestic demand and gorged on exports.

Where might alternative sources of demand come from? That’s easy – it can come from Chinese, German and Japanese households none of which participated in the “developed country” consumption splurge.

If those households could be mobilized to spend some of their vast savings by appropriate policy measures then world demand could be rebuilt on a basis which saw current account balances restored to neutral levels. That is, the USA would move into surpluses via exports, and China, Germany and Japan would move into much smaller surpluses and eventually into balance. Within Europe the Club Med countries would also need to rebuild export capability to balance their current accounts vis- a- vis Germany and to replace burnt out households as a demand source. This they could achieve by exiting the EZ and devaluing.

The ingredients of a grand deal would look something like this (there are many variants on this theme):

  • China would take aggressive policy measures  to reorientate its economy towards more household consumption and much less infrastructure investment;
  • Germany and Japan would also stimulate household consumption and reduce their dependence on exports;
  • Currency realignments would be agreed to support these reorientations, including those required to assist the PIIGS;
  • Temporary funding support would be provided by the surplus countries (China, Germany, Japan) to facilitate the necessary economic transitions; and
  • The USA would agree to limit further QE (and inflation) and would support the USD at a defined value.

Grand bargains have been struck before – for example at Bretton Woods in 1944 and in the Plaza Hotel 5th Avenue in 1985. Will it happen again? No – not any time soon because in addition to the complex policy issues the political obstacles are overwhelming in the context of the current election cycle in the USA and the leadership transition next year in China.

Moreover, if China sees in the current situation the potential for the total breakdown in Western economic leadership, why not just watch the ship sink? That, beyond everything, is the question of the decade and maybe of our generation.

But if the Chinese can be persuaded that their interests do not lie in the direction of an implosion of the developed economies, then thereafter one might see a glimmer of hope as the world faces up to its two harsh options – either do a comprehensive deal realigning economies around available sources of demand, or face a very prolonged period of adjustment by slow degrees accompanied, one fears, by serious political upheaval.

So What?

You can slice and dice the answers to three questions above to generate a lot of different scenarios-none of them very attractive. And you can fold into the mix a wild card which is the potential for the Bi-Partisan Committee on US deficit reduction to surprise us all with an effective package delivering further short term stimulus coupled with longer term disciplines and a solution to the housing conundrum.

But viewed as a whole Macca says expect more bad news and keep your powder dry. Things probably have to get worse before they get better.

In fact there is no shortage of folk who see in this crisis the demise of liberal democracy and free market capitalism itself.[5] Macca used to scorn such predictions as rubbish but he does so no longer.

Sometimes people live through major inflection points in history without knowing it. How many Frenchmen understood that the revolution of 1789 would transform the world for centuries and how many Soviets understood that Perestroika heralded the demise of the Soviet Union?

Maybe we too are living through such a moment. The break up of the EZ-and possible end of the European project-would be bad enough, but if China decides to stay on the sidelines and dissemble, then all bets are off.

On the positive side, adversity can breed great leaders. That isn’t Obama, Merkel or Kan for sure – but maybe from left field our FDR or Thatcher will emerge. We live in hope.

20 comments on “Big trouble ahead ”

  1. Zaphod Beeblebrox 1

    Yet NZ is going to grow at 4% p.a and be out of deficit in 3 years!! Well thats what Treasury think.

    • Blighty 1.1

      you callin’ Treasury a liar?

      Well, they were 1.1% out about March quarter growth, that’s the quarter that was already over when they made the prediction…

      can’t predict the past, can’t predict the future.

  2. tsmithfield 2

    Take puts on the SPY.

    You’ll make a fortune if it all turns to custard. I suggest you wait until about Thursday though, because there is quite a strong relief rally going at the moment with the expectation that Bernarke might pull a rabbit out of his hat at the Jacksons Hole meeting. That will probably disappoint expectations, so it will be a case of “selling the news”.

    • Colonial Viper 2.1

      S&P 500 is going to 500.

    • Bored 2.2

      You’ll make a fortune if… You might wish to check my predictions for the last 4 years or more, they have all been pretty much on the button, timing variable but pretty good. Should you wish to take a position with a bookie or broker to profit on this all I ask that you give “my very minor cut” (for the advice) to a registered charity of your choice. Good luck.

      PS Yes I have put my money where my mouth is: its grown numerically but I doubt it is worth as much.

  3. vto 3

    Couple of long held ideas to throw into the mixing barrel….

    Perhaps it is the case that people now have enough stuff. Dont need or want anymore consumer items like the next flash tv, or a better car, or some fandangled kitchen wizz item, or some weirdo decoration for the wall. People are changing to simplicity and seeing those with loads of stuff as somehow silly. As such the entire concept of growth and it being fuelled by spending is simply going to go nowhere.

    Secondly, regarding the debt mountains of nations, I am going to repeat my call that it should be defaulted. Or it should be unilaterally extended out for a large number of years, and with no compounding interest. It may have been silly to borrow it but it was equally silly to lend it. Both need to take the haircut. This default scenario is the only way to get back to some kind of sustainable economy. The needs of the people at this time must come first, and repayment of these debts a distant second. Tough biccies to the lenders. The people must come first.

    • Colonial Viper 3.1

      It may have been silly to borrow it but it was equally silly to lend it.

      Usual strategy was to lend countries huge amounts of money beyond which they could ever repay (eg every man woman and child in Greece owes something like US$50K each).

      Then have multinational corporates (e.g. Halliburton, ExxonMobil etc) contracted to the lender to do expensive infrastructure work, provide military arms etc.

      So the foreign rich loan the local poor the money, and charge interest on it, making a profit. The overseas corporations belonging to the foreign rich then get contracted to do work for the local poor, extracting that newly leant money back for the foreign rich.

      Local politicians and officials are bought off along the way. For a $2B loan, $40M in bribes and back handers is simply a 2% cost of doing business.

      The local poor then struggle to pay the loans back, giving the foreign rich an entry point to seize valuable state assets and other collateral for cents on the dollar.

      • AAMC 3.1.1

        Which is why the PIIGS should follow Icelands lead…

        “This required each Icelandic citizen to pay 100 Euros a month (or about $130) for fifteen years, at 5.5% interest, to pay off a debt incurred by private parties vis a vis other private parties. It was the straw that broke the reindeer’s back.
        What happened next was extraordinary. The belief that citizens had to pay for the mistakes of a financial monopoly, that an entire nation must be taxed to pay off private debts was shattered, transforming the relationship between citizens and their political institutions and eventually driving Iceland’s leaders to the side of their constituents.”
        http://www.dailykos.com/story/2011/08/01/1001662/-Icelands-On-going-Revolution

      • In Vito Vertias 3.1.2

        Jeepers Colonel, using Greece is a bad example for you lefties, surely? Politically corrupt, with massive bureaucratic inefficiency and overt tax evasion from those bureaucrats. A country that since 1974, has historically run large deficits to finance public sector jobs, pensions and social benefits. Borrowing to keep a standard of living that hasn’t been earned. Nice one Greece. Down the pan you go. Its probably pertinent to mention that the Pan Hellenic Socialist Movement has been in power for a good portion of time since 1981. Socialism, great until you run out of other peoples money. And guess what, Greece ran out of other peoples money, and what is even better, they’ve been rioting about it!!

  4. Peter 4

    To use a Marxist concept – he has the superstructure analysis right, but he misses the fundamentals. The world is in a predicament brought on by depleting resources, and unlike problems, predicaments don’t have solutions, only adaptations.

    However, most of our politicians seem to believe that with the right mix of financial redesigns, we can magick away that predicament. I don’t know how long it takes people to emerge from a denial stage to an acceptance stage, but some seem to have been stuck in denial for a very long time.

  5. randal 5

    the great crash of 1929 was only resolved with the the advent of WWII. Heaven forbid that such an event is necessary now but the other posters are on the right track. The world is going thorugh a sea change now and the geeks in charge are having one last fling before the madness starts.

    • aerobubble 5.1

      The great crash was due to cheap energy. Keenly Hitler understood this. He built the
      autobahns, he saw (like many others) that the winner would be those that become
      manufacturing powerhouses, and seize resources of other nations who got in his way.
      Hitler however was also a weak man who got very good at infecting others with
      his own fears and paranoia.

      Cheap high density fuel era is over. This is more like the economic malaise of the
      end of the nineteen century. Successive collapses of markets. But there was no
      climate change collapse, or hopelessly clueless globalized MSM peddling lies to
      their viewers (the voters).

  6. James 6

    but maybe from left field our FDR or Thatcher will emerge. We live in hope.

    We’re hoping for another Thatcher? WTF?

  7. Afewknowthetruth 7

    We are witnessing the early stages of the reversal of the Industrial Revolution.

    Peak per capita energy was around 1979, and we have now passed peak absolute energy (yet world population is still rising, for the moment). And the ‘idiots’ in charge still talk in terms of economic growth1 Yeah right, we will have global economic growth if we can find those four Saudi Arabias that have gone missing, along with all their oil.

    It probably goes without saying but for clarity I will say it: nothing within the paradigms of mainstream economics can fix the mess we are in, and everything within the pardigms of mainstream economics makes everything that matters worse.

    The only soft-landing way out of this mess is an organised energy descent and a rapid shift to permaculture-based local food production. The hard-landing way is via a complete crash of the system which will bring about mass starvation and population die-off. (A degree of population die- off is inevitable anyway, since the huiman population is already way past the long term carrying capacity of this planet)

    Bearing in mind the bankers’ Ponzi scheme demands perpetual growth [on a finite planet] – a bizarre concept if ever there was one- and we don’t see any official support for powerdown and permaculture, that leaves the second scenario -crash and burn- as the most likely outcome.

    • Draco T Bastard 7.1

      Crash and burn the most likely for the vast majority of the worlds population no matter what happens as they just cannot be supported within their local natural environment. That said, some places could do a move to a permaculture if the people were made truly aware of the consequences of not doing so. Unfortunately, very few people are even trying to bring that awareness to the general population and the bankers and politicians seem to be actively working to prevent it.

      • Zaphod Beeblebrox 7.1.1

        No profit in self-subsidence.

        We could also generate our own electricity from our rooves then make a profit selling it back to Transpower. Can’t alow that- might depress the price of some of our electricity SOEs.

    • mikesh 7.2

      “since the huiman population is already way past the long term carrying capacity of this planet”

      We can’t be way past the carrying capacity of the planet, otherwise many of us would not be here.

      • James 7.2.1

        Many of us aren’t here. Heard of the drought in Africa?

        We are using more resources than the planet can replace. I believe we passed that point near the middle of last year.

  8. Afewknowthetruth 8

    Death by a thousand cuts:

    Japan sees credit rating downgraded

    AP

    Wednesday, 24 August 2011

    Moody’s Investors Service downgraded Japan’s credit rating, citing the country’s weak growth prospects, massive government debt and constant political turmoil.

    Moody’s cut Japan’s government bond rating to Aa3 from Aa2. The new rating is three notches below Moody’s top Aaa rating. It said the outlook for the rating is stable in a statement released early in the Asian financial day today.

    The downgrade puts Moody’s Japan rating in line with other major agencies. Both Standard & Poor’s and Fitch rate Japan AA-, three notches below their top AAA ratings.

  9. infused 9

    2nd recession is setting in.

    3rd recession in 1.5 years time. Then we will see a change.

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