28 January 2009

Eight Structural Factors Undermining Any Turn-Around

by Simon Smelt January 26, 2009

Beyond rescue efforts and hopes of restoring confidence, deep structural forces remain unresolved. Current actions could make matters worse. Consider these eight factors:

First: We are off the map. The U.S. Federal Reserve and Treasury, like their counterparts around the world, face unprecedented challenges. Bank deposits with the Fed, the monetary base, interest rates in the United States and United Kingdom are all at historic highs or lows. Sophisticated tools of economic management are deployed, yet there is no sign that financial leaders have found maps to guide them beyond the immediate need for survival. They can’t even agree the cause: was it a global savings glut (former Treasury Secretary Henry Paulson) or bankers’ behavior (former Fed Chairman Alan Greenspan). They just want to get out of the hole quick. Little is heard of how to tackle America’s empire of debt.

Second: The compass is gone. The focus of monetary policy around the world has been keeping inflation (as measured by the Consumer Price Index) under control and, subject to that, encouraging economic activity through low interest rates. But, this assumes that: (1) The market – guided by light-handed regulation – would look after the rest, notably risk; and (2) prices not covered by CPI – such as asset prices – didn’t matter much for the purposes of monetary management.

Well, wrong on both counts. Result: there are no clear, long-term policy settings for central banks to follow. This makes life unpredictable – just what markets don’t like.

Third: The transmission and steering are shot. The stimulus of competition and the market is being weakened by the growing role of government. More lobbying and more rescue packages will weaken economic performance.

Unlike other central banks, the Fed is not part of government, yet it is a key player. At international level, the elaborate Basle II accord to regulate banking has proved ineffective because it does not catch securitisation.

Fourth: The engine room has throttled back. The engine for global growth has been the U.S. consumer. This stems not from real wage growth but from the availability of cheap credit and the wealth effects of asset price inflation. Growth of 12% plus per annum in household borrowing is unsustainable. Consumption will stay shut down because of reduction in both the supply of credit (factor five) and the demand for credit.

U.S. households have consistently grown their wealth by 3% per annum, compounded, in the medium to long term. In the last 20 years, this has been achieved through capital gains not savings – boosting consumption and encouraging borrowing. The 2008 shock removes those gains. Households will save more, lowering consumption. A return to previous savings rates would result in a $1 trillion per annum decline in U.S. gross domestic product (GDP).

Fifth: The fuel supply is low. Much has been written about the reduced availability of credit. The government and Fed are stepping in to fill the gap in various ways. But:

Sixth: The tugboat can’t do it. There are three big problems.

First, government’s operational limits. In the United States, government accounts for 20% of GDP. The harsh transition to a post bubble world is putting pressure on government to expand to replicate the size or pattern of lost economic activity or to enforce spending and lending; e.g. coercing banks to lend more, regulating old cars off the road so as to speed the replacement cycle for cars, and so on.

Second, monetary policy carries dangers. With reduced leverage by banks and reduced consumption by households, both the quantity of money and the velocity of its circulation will fall. This shrinks nominal GDP. For the Fed’s monetary levers to precisely counterbalance this fall is impossible. If the Fed undershoots, this leads to deflation and recession. Fed Chairman Ben Bernanke will err towards overshoot but the resulting inflation will be difficult to control.

Third, U.S. government debt is climbing, whilst reduced economic growth makes it harder to absorb consequent claims on future revenue. Increased borrowing by government is a burden on future generations of taxpayers.

These three problems show that the boundaries for government action will be pushed hard. However great a leader new President Barack Obama may be, the U.S. government cannot fulfil its long to-do list from the downturn, and repay increasing borrowings, and meet its growing future obligations and ensure a healthy and competitive economy. Yet, political as well as borrowing pressures encourage it to try.

Seventh: Confused signals. Taxpayer funded bailouts seek to save businesses, avoid outright nationalization and forestall panic exit of remaining private capital.

But, in consequence, government’s role has grown from providing welfare insurance to financial insurance. A net transfer from the prudent to the imprudent and from future generations to this is enforced. Consequences of mistakes are borne by those who did not make them.

The signals are perverse and reinforced by leaders. In a guilt free society, Paulson and Treasury Secretary-designate Timothy Geithner view greedy and unwise U.S. consumers and bankers as victims of Asian lenders: “China made me do it!”

Eighth: Stormy international waters. The United States is the world’s main debtor and its dollars provide liquidity to global trade. Eighty-five percent of international trade is in the world’s reserve currency – the U.S. dollar. Foreigners buy 80% of U.S. Treasury bills. To keep its factories churning, China and other exporters buy U.S. dollars – effectively providing goods on credit. All this is of vast benefit to the United States but could change.

The tipping point may come in 2010 from the mundane issuance of government bonds. New government spending programs and the downturn in tax revenues will require many governments massively to expand bond issues to cover their debt.

This will mean: (1.) Downward pressure on bond prices (higher yields), and (2) sufficient supply of non U.S. government bonds that big money can shift from U.S. assets. A lot of parked investment money will be looking for a good home. How much more exposure to U.S. debt – and “victim” psychology – will investors want?

These eight factors are a formidable combination to overcome. Lifeboats anybody?

Simon Smelt is a New Zealand-based economist and policy analyst.

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