The Great Contraction will last a while longer
This financial crisis will end. The Great Contraction of the Noughties also will come to an end. But neither the financial crisis nor the contraction of the global real economy are over yet. As regards the financial sector, we are not too far – probably less than a year – from the beginning of the end. The impact of the collapse of real economic activity and of the associated dramatic increase in defaults and insolvencies by non-financial enterprises and households on the loan book of what is left of the banking sector will begin to show up in the banks’ financial reports at the end of the summer and in the autumn. By the end of the year – early 2010 at the latest – we will know which banks will survive and which ones are headed for the scrap heap. With the resolution of the current pervasive uncertainty about the true state of the banks’ balance sheets and about their off-balance-sheet exposures, normal financial intermediation will be able to resume later in 2010.
Governments everywhere are doing the best they can to delay or prevent the lifting of the veil of uncertainty and disinformation that most banks have cast over their battered balance sheets. The banking establishment and the financial establishment representing the beneficial owners of the institutions exposed to the banks as unsecured creditors – pension funds, insurance companies, other banks, foreign investors including sovereign wealth funds – have captured the key governments, their central banks, their regulators, supervisors and accounting standard setters to a degree never seen before.
I used to believe this state capture took the form of cognitive capture, rather than financial capture. I still believe this to be the case for many, perhaps even most of the policy makers and officials involved, but it is becoming increasingly hard to deny the possibility that the extraordinary reluctance of our governments to force the unsecured creditors (and any remaining non-government shareholders) of the zombie banks to absorb the losses made by these banks, may be due to rather more primal forms of state capture.
History teaches us that systemic financial crises are protracted affairs. A most interesting paper by Carmen M. Reinhart and Kenneth S. Rogoff, “The Aftermath of Financial Crises”, using data on 10 systemic banking crises (the “big five” developed economy crises (Spain 1977, Norway 1987, Finland, 1991, Sweden, 1991, and Japan, 1992), three famous emerging market crises (the 1997–1998 Asian crisis (Hong Kong, Indonesia, Malaysia, the Philippines, and Thailand); Colombia, 1998; and Argentina 2001)), and two earlier crises (Norway 1899 and the United States 1929) reaches the following conclusions (the next paragraph paraphrases Reinhart and Rogoff).
First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent over six years; real equity price declines average 55 percent over a downturn of about 3.5 years. Second, the aftermath of banking crises is associated with large declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, but the duration of the downturn averages around 2 years.
Nothing more can be expected as regards a global fiscal stimulus. Indeed, the G20 delivered nothing in this regard. It would have been preferable to maintain the overall size of the planned (or rather, expected) global fiscal stimulus but to redistribute the aggregate (about $5 trillion over 2 years, as measured by the aggregated changes in the national fiscal deficits) in accordance with national fiscal spare capacity (I believe the World Bank calls this ‘fiscal space’). This would mean a smaller fiscal stimulus for countries with weak fiscal fundamentals, including the US, Japan and the UK, and a larger fiscal stimulus for countries with strong fiscal fundamentals, including China, Germany, Brazil and, to a lesser degree, France.
The effect of the Great Contraction on potential output growth
Furthermore, a likely consequence of the fiscal stimuli we have already seen or are about to experience is a negative impact on the medium- and long-term growth potential of the global economy. The reason is that, if fiscal solvency is to be maintained, there will have to be some combination of an increase in the tax burden and a reduction in non-interest public spending in most countries when this contraction is over. The inevitable effect of the crisis and the contraction is a higher public debt burden and therefore a larger future required primary government surplus (as a share of GDP). Almost any increase in the tax burden will hurt potential output – just the level of the path of potential output if you are a classical growth groupie, both the level and the growth rate of the path of potential output if you are an adept of the endogenous growth school.
In the study of Reinhart and Rogoff cited earlier, the authors conclude that the real value of government debt tends to explode following a systemic financial crisis, rising an average of 86 percent in major post–World War II episodes. The principal cause of these public debt explosions is not the costs of “bailing out” and recapitalizing banking system. The big drivers of these public debt burden increases are rather the collapse in tax revenues that comes with deep and prolonged output contractions (the operation of the automatic stabilisers) and discretionary counter-cyclical fiscal policies.
For political expediency reasons, cuts in public spending are likely to fall first on maintenance, public sector capital formation and other forms of productive public expenditure, including spending on education, health and research. Welfare spending in cash or in kind is likely to be the last to be cut. The result is again likely to be a lower level (or level and growth rate) of the path of potential output.
The risk of ‘sudden stops’ in the overdeveloped world
In a number of systemically important countries, notably the US and the UK, there is a material risk of a ‘sudden stop’ – an emerging-market style interruption of capital inflows to both the public and private sectors – prompted by financial market concerns about the sustainability of the fiscal-financial-monetary programmes proposed and implemented by the fiscal and monetary authorities in these countries. For both countries there is a material risk that the mind-boggling general government deficits (14% of GDP or over for the US and 12 % of GDP or over for the UK for the coming year) will either have to be monetised permanently, implying high inflation as soon as the real economy recovers, the output gap closes and the extraordinary fear-induced liquidity preference of the past year subsides, or lead to sovereign default.
Pointing to a non-negligible risk of sovereign default in the US and the UK does not, I fear, qualify me as a madman. The last time things got serious, during the Great Depression of the 1930s, both the US and the UK defaulted de facto, and possibly even de jure, on their sovereign debt.
In the case of the US, the sovereign default took the form of the abrogation of the gold clause when the US went off the gold standard (except for foreign exchange) in 1933. In 1933, Congress passed a joint resolution canceling all gold clauses in public and private contracts (including existing contracts). The Gold Reserve Act of 1934 abrogated the gold clause in government and private contracts and changed the value of the dollar in gold from $20.67 to $35 per ounce. These actions were upheld (by a 5 to 4 majority) by the Supreme Court in 1935.
In the case of the UK, the de facto sovereign default took the form of the conversion in 1932 of Britain’s 5% War Loan Bonds (callable 1929-1947) into new 3½ % bonds (callable from 1952) on terms that were unambiguously unfavourable to the bond holders. Out of a total of £2,086,000,000 outstanding, £1,500,000,000, or something over 70%, was converted voluntarily by the end of 1932, thanks both to the government’s ability to appeal to patriotism and joint burden sharing in the face of economic adversity and to ferocious arm-twisting and ‘moral suasion’.
I believe both defaults were eminently justified. There is no case for letting the interests of the holders of sovereign debt override the interests of the rest of the community, regardless of the financial, economic, social and political costs involved. But to say that these were justifiable sovereign defaults does not mean that they were not sovereign defaults. Similar circumstances could arise again.
While I consider an inflationary solution to the public debt overhang problem (and indeed to the private debt overhang problem) to be more likely in the US and even in the UK than a sovereign default (or ‘restructuring’, ‘conversion’ or ‘consolidation’, as it would undoubtedly be referred to by the defaulting government), neither can be dismissed as out of the question, or even as extremely unlikely.
Central banks: a mixed bag
Central banks, with the notable exception of the procrastinating ECB, are doing as much as they can through quantitative easing and credit easing to deal with the immediate crisis. Unfortunately, some of them, notably the Fed, are providing these short-term financial stimuli in the worst possible way from the point of view of medium- and longer-term economic performance, by surrendering central bank independence to the fiscal authorities.
When the Fed lends on a non-recourse basis to the private sector with only a $100 bn Treasury guarantee for a possible $1 trillion dollar Fed exposure (as with the TALF), when the Fed purchases private securities outright with just a similar 10-cents-on-the-dollar Treasury guarantee or when the Fed is party to an arrangement that transfers tens of billions of dollars to AIG counterparties – money that is likely to be extracted ultimately from the beneficiaries of other public spending programmes or from the tax payer, either through explicit taxes or through the inflation tax – the Fed is acting like an off-balance sheet and off-budget special purpose vehicle of the US Treasury.
When the Chairman of the Fed stands shoulder-to-shoulder or sits side-by-side with the US Treasury Secretary to urge the passing of various budgetary proposals – involving matters both beyond the Fed’s mandate and remit and beyond its competence – the Fed is politicised irretrievably. It becomes a partisan political player. This is likely to impair its ability to pursue its monetary policy mandate in the medium and long term.
The G20 wind egg
The global stimulus associated with the increase in IMF resources agreed at the G20 meeting earlier this month will be negligible unless and until these resources actually materialise. The statements, declarations and communiqués of the G20, including the most recent ones highlight the gaps between dreams and deeds.
Even the promise of an immediate increase in bilateral financing from members of $250 bn is not funded yet. Only $200 have been promised firmly – $100 bn by Japan and $100 bn by the EU. Prime Minister Brown announced that the PRC had committed another $40 bn, but apparently he had forgotten to clear this with the Chinese.
As regards the plan to incorporate in the near term, the immediate financing from members into an expanded and more flexible New Arrangements to Borrow would be increased by up to $500 billion (that is by another $250 bn). Unfortunately, nobody has volunteered any money yet. It therefore has no more substance than past commitments by the international community to fund the achievement of the Millenium Development Goals.
Then there is the promise that the G20 will consider market borrowing by the IMF to be used if necessary in conjunction with other sources of financing, to raise resources to the level needed to meet demands. That is classic official prittle-prattle – suggesting the IMF borrow without providing it with the resources (capital) to engage in such borrowing.
There is also $6 bn for the poorest countries, to be paid for by IMF gold sales and profits. Nice, but chicken feed.
Finally there is the decision to support a general allocation of SDRs equivalent to $250 billion to increase global liquidity, $100 billion of which will go directly to emerging market and developing countries. The problem is that this requires the approval of the US Congress, which is deeply hostile to any additional money for any of the Bretton Woods institutions. A special allocation of SDRs is also out of the question, because the US has not yet ratified the fourth amendment to the IMF’s articles (approved by the IMF’s Board of Governors in 1997!).
So apart from the $240 bn (or perhaps only $200 bn) already flagged well before the G20 meeting, the only hard commitment to additional resources (or to resources that have any chance of being available for lending and spending during the current contraction) is the $6 bn worth of alms for the poor from the sale of IMF gold. That’s what I call a bold approach!
The Multilateral Development Banks may well be able to increase their lending by $100 bn as announced by the G20, even with existing capital resources.
The increase in trade credit support announced at the G20 meeting is very modest indeed – $250 bn could be supported (mainly through guarantees, I suppose) over the next two years.
As regards protectionism, we must be grateful for the vast difference between today’s relatively mild manifestations and the virulent protectionism of the 1930s. But again, the last few G20 meetings have yielded not a single concrete protectionism-reducing measure.
There are signs that the rate of contraction of real global economic activity may be slowing down. Straws in the wind in China, the UK and the US hint that things may be getting worse at a slower rate. An inflection point for real activity (the second derivative turns positive) is not the same as a turning point (the first derivative turns positive), however. And even if decline were to end, there is no guarantee that whatever growth we get will be enough to keep up with the growth of potential. We could have a growing economy with rising unemployment and growing excess capacity for quite a while.
The reason to fear a U-shaped recovery with a long, flat segment is that the financial system was effectively destroyed even before the Great Contraction started. By the time the negative feedback loops from declining activity to the balance sheet strenght of what’s left of the financial sector will have made themselves felt in full, financial intermediation is likely to be severely impaired.
All contractions and recoveries are primarily investment-driven. High-frequency inventory decumulation causes activity to collapse rapidly. Since inventories cannot become negative, there is a strong self-correcting mechanism in an inventory disinvestment cycle. We may be getting to the stage in the UK and the US (possibly also in Japan) that inventories stop falling an begin to build up again.
An end to inventory decumulation is a necessary but not a sufficient condition for sustained economic recovery. That requires fixed investment to pick up. This includes household fixed investment – residential construction, spending on home improvement and purchases of new automobiles and other consumer durables. It also includes public sector capital formation. Given the likely duration of the contraction and the subsequent period of excess capacity, even public sector infrastructure spending subject to long implementation lags is likely to come in handy. A healthy, sustained recovery also requires business fixed investment to pick up.
At the moment, I can see not a single country where business fixed investment is likely to rise anytime soon. When the inventory investment accelerator goes into reverse and starts contributing to demand growth, and when the fiscal stimuli kick in, businesses wanting to invest will need access to external financing, since retained profits are, after a couple of years of declining output, likely to be few and far between. But with the banking system on its uppers and many key financial markets still disfunctional and out of commission, external financing will be scarce and costly. This is why sorting out the banks, or rather sorting out the substantive economic activities of new bank lending and funding, that is, sorting out banking , must be a top priority and a top claimant on scarce public resources.
Until the authorities are ready to draw a clear line between the existing banks in western Europe and the USA, – many or even most of which are surplus to requirements and have become parasitic entities feeding off the tax payer – and the substantive economic activity of bank lending to non-financial enterprises and households, there will not be a robust, sustained recovery.