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Can we borrow our way out of the credit crunch?

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By Leigh Skene, Lombard Street Research – The two factors that turned the 1930s into the worst depression since the Industrial Revolution were the collapse of the payments system and the global run on banks. Neither is likely this time.

The US has failed to maintain the dollar as a store of value, abrogating its responsibility as the agent of the reserve currency. However, the international payments system has already adjusted and so won’t collapse as it did in the 1930s. In addition, fiat money eliminated the ability to withdraw reserves from banks and deposit insurance has guaranteed the safety of the deposits of individuals in most advanced nations so, the Northern Rock fiasco notwithstanding, runs on banks have become an anomaly.

Comparing the recent credit crisis with the 1930s is risible, but both the 1930s and the current difficulties resulted from the end of a period of credit rising faster than GDP. The ends of credit cycles alter economic and financial responses to various stimuli, so the future will differ greatly from the past.

Debt liquidation is deflationary Excess credit creation always ended in credit liquidation and deflation in the past. However, the fiscal multiplier has made governments the biggest beneficiaries of inflation and they are doing everything in their power to stave off deflation. Governments’ two most effective tools against deflation are quantitative easing and fiscal stimulation.

Quantitative easing is intended to create enough money to stimulate asset price appreciation, which should then raise spending and income even though the private sector is paying off debt.

Quantitative easing is a short term palliative. It can smooth the transition from high private debt accumulation but, in the long term, only saving and investment can create wealth. The function of credit is to transfer savings from savers to the people with the optimum ability to invest the savings in useful assets.

It’s important to distinguish between sustainable credit and unsustainable credit. Sustainable credit transfers savings from the savers to borrowers who can use that saving to create long-lasting tangible assets. Repaying the debt as the assets depreciate ensures claims on tangible assets back all credit. Monetary stimulation increases credit faster than saving and so creates unsustainable credit. All creditors believe they have claims to real assets, but the credit in excess of saving has no real foundation, so asset prices must rise as fast as the claims on them or some claims will be abrogated.

Claims won’t be abrogated while GDP is rising as fast as asset prices, but incomes become insufficient to service the rising debts when asset prices rise faster than GDP. Then defaults rise as creditworthiness falls, the ability to keep borrowing disappears and asset prices fall. The private sector in borrow-andspend nations ran out of the ability to service its debts in 2007, so the unsustainable part of the debt will be liquidated. This liquidation has barely begun and will accelerate.

Debt liquidation is deflationary because it destroys money. Governments are trying to prevent default by guaranteeing some private sector liabilities and absorbing others, saddling taxpayers with the losses. A growing number of nations can’t meet all these commitments and now exist on supranational agency handouts. How many nations the supranational agencies can support is unknown, but we’ll probably find out.

Defaults are vaporising equity, so banks retained most of the funds that quantitative easing provided in their reserves. People generally presume the excess reserves will be loaned at the first opportunity, but that is unlikely. Banks are close to loaned out, they must ensure they remain liquid as loan losses rise and their liquid assets (including excess reserves) are at a normal level. Leaving excess reserves on deposit at the Fed is the most convenient and profitable way to invest day-to-day funds. Excess reserves should remain high until the Fed tightens, which won’t be for a long time as developed nation economies are structurally weak.

Real GDP growth is trending down and credit liquidation is deflating demand, rising protectionism will impair world trade, sated consumers and aging populations are reducing growth, rising relative costs of food and energy are lowering discretionary income, excess capacity is at record levels and bigger fiscal deficits and anti-business legislation will seriously impair productivity. The population available for and the participation rate in the labour force are falling, multifactor productivity is rising slowly and tax increases will hold growth below potential. Thus, the fear quantitative easing will cause inflation is misplaced.

Taxes and fiscal deficits will reduce investment and productivity The Congressional Budget Office estimates federal revenues will rise by 3.4% of GDP by 2013 – before the cost of either the cap-and-trade carbon bill that would effectively be a tax of about 11/2% of income or the health care bill that would raise the top marginal income tax rate from 35% to 48%. In addition, higher energy costs will have the effect of an additional tax increase.

Studies show a specific tax rise of 1% of GDP reduces cumulative output over the next three years by 2-3% of GDP due to the big impact of tax hikes on saving and investment. Gross US investment fell 28% in the year ending in Q2 2009 to 11.5% of GDP – below current capital consumption allowances, which are 13.2% of GDP. The US is now consuming capital for the first time since WWII and net private investment in Q2 2009 was 3.4 percentage points of GDP lower than the previous all-time low in 1982. Capital replacement increases productive capacity by about 2% a year. 

America has been growing at 2% a year and US business net investment over the last seven years totalled only 0.1% of GDP. 3rd quarter productivity has fallen from 3.8% to 2.2% a year in the last five years due to lack of net investment.

Table 1 Government Deficits % of GDP

  2009
Budget

Structural

2010
Budget
Structural
US 13.6 6.9 9.7 6.5
UK   9.8 6.7 10.9 6.1
Japan   9.9 6.5 9.8 6.5
Major Advanced 10.4 5.1 8.7 5.3
         
         

Table 1 shows US budgetary problems are far from unique. Efforts to combat the continuing below trend growth probably will push structural deficits up after 2010 and cyclical deficits will often add to them. Budget deficits are likely to average 7% to 9% of GDP in the US, the UK, Japan and other developed nations for a long time. The financial balances of the private, government and foreign sectors must add up to zero. The government fiscal deficit is forecast to be 11.9% of GDP in 2009, so private and foreign sector financial balances must add up to about 11.9% of GDP.

Table 2. US Financial Balances % of GDP

  Q1 2008 Q2 2009 2009 2010 2011
Government -3.9 -10.6 -11.9 -10.3 -8.0
Personal -3.6 1.4 1.5 1.5 1.5
Business 2.2 5.0 6.0 6.0 2.3
Foreign 4.9 2.7 4.2 4.2 4.2

Inadequate American savings make this a gigantic hurdle. Gross domestic saving has seldom covered investment, so America has imported foreign saving since 1975. Personal savings rose from 0.9% of GDP in early 2008 to 3.9% in Q2 2009. The desire to save will remain strong, but government accounted for a record one-fifth of personal income in the quarter. Reduced income transfers over and above the automatic stabilizers, unemployment and deflation will probably prevent personal saving from growing much above the Q2 level.

Investment in housing fell to a post war low of 2.4% of GDP in Q2 2009 and is unlikely to rise much for a considerable period giving a personal financial balance of 3.9% – 2.4% = 1.5% of GDP.

Mortgage problems are far from solved Inadequate American savings make this a gigantic hurdle. Gross domestic saving has seldom covered investment, so America has imported foreign saving since 1975. Personal savings rose from 0.9% of GDP in early 2008 to 3.9% in Q2 2009. The desire to save will remain strong, but government accounted for a record one-fifth of personal income in the quarter. Reduced income transfers over and above the automatic stabilizers, unemployment and deflation will probably prevent personal saving from growing much above the Q2 level.

Investment in housing fell to a post war low of 2.4% of GDP in Q2 2009 and is unlikely to rise much for a considerable period giving a personal financial balance of 3.9% – 2.4% = 1.5% of GDP.

Mortgage problems are far from solved A similar analysis applies to other nations. For example, business investment in Britain fell low enough to raise the business financial balance to 9% of GDP in Q1 2009. This offset most of the government financial balance of 10% of GDP. Business investment is unlikely to recover any time soon as government financial deficits will rise in fiscal 2010.

Debt to GDP ratios will soar A recent paper to the American Economic Association showed public debt rises an average of 86% above its pre crisis level in real terms in the three years following a banking crisis. The recent banking crisis was the worst and remedial measures by far the greatest since the Great Depression, so we can be sure real public debt will rise much more than 86% over its pre crisis levels in many OECD nations.

Japanese government debt soared from 50% of GDP in 1989 to over 180% before the government began a program of debt reduction in 2003. US Treasury debt was 721/2% of GDP at the end of fiscal 2008 – including the notional $41/2 trillion of debt in the social security funds. Extending the figures in Table 2 produces about $25 trillion of debt and a debt-to-GDP ratio of 146% in 2019.

That would only lower the rating on Treasury debt to AA, but the credit cycle ended because the additional GDP per unit of debt became too small for private sector borrowers to service their debts.

Blanket guarantees, bailouts and moving private sector loans onto public balance sheets shifted the cost of bad loans to taxpayers. These contingent liabilities and investments will add to the fiscal deficits enumerated above. Guarantees don’t involve an outlay of funds unless a default occurs, and the others aren’t current expenditures, but governments must borrow to the funds required for these activities, so they will raise the debt-to-GDP ratio.

Default rates quadrupled in 2008 and are expected to quadruple again in 2009.

Soaring default rates are causing plummeting recovery rates, so taxpayer losses will be substantial. Adding the losses on guarantees and investments to the fiscal deficits would raise the US debt in 2019 to about 200% of GDP. The debt-to-GDP ratio tripling in 10 years would be worrisome and also crowd out new private sector borrowing – lowering growth in output, productivity and living standards. Unfortunately, the story doesn’t end here as these figures don’t include the potential losses from the coming bulge in debt maturities that will be hard to refinance.

Five serious credit problems remain The sub-prime mortgage crisis is behind us, but trashed household balance sheets still present problems 1-3 below, and trashed business balance sheets present problems 4 and 5 and problem 6 is the inevitable result of the other five.

1. Monthly mortgage resets are rising from a low this summer to a peak in 2011 higher than the 2008 peak. Probable defaults mean we may be half way through residential mortgage defaults and foreclosures.

2. Household liabilities in delinquency and default rose to $1.15 trillion in June, 10% of total liabilities. Rising unemployment is raising the default rate, so relief won’t be visible for some time.

3. Federal Housing Administration guaranteed mortgages are rising geometrically and many have the characteristics of sub-prime loans: highrisk borrowers, low down payments and shady mortgage originators.

4. High loan to value ratios, falling real estate prices and losses will make refinancing the $3 trillion of US commercial real estate debt maturing in the next three years difficult.

5. Most of the $1.3 trillion US leveraged loans outstanding will need refinancing by 2012. Most are very low grade and were securitized, creating a big refunding problem.

6. The Federal Deposit Insurance Corporation (FDIC) insurance premiums are woefully inadequate, so Congress has given it $500 billion, but taxpayers have no guarantee $500 billion will be enough.

Conclusion Excess monetary stimulation raised asset prices faster than GDP growth until the private sector could no longer borrow enough to maintain the rise in asset prices. Asset prices then collapsed, causing a credit squeeze. Many think today’s quantitative easing is just a turbocharged version of the ‘Greenspan put.’ In addition, major financial institutions now take their huge risks with taxpayer guarantees. Can moral hazard possibly rise from here? Repayment is deflationary and OECD economies are structurally weak, so growth will be very slow. Fiscal policy in many nations resembles American fiscal policy in the 1930s – and will result in the same poor outcome. Big deficits are hoovering up saving and so driving down investment, productivity and living standards.

Sovereign debt to GDP ratios will soar before governments even begin to tackle the above-mentioned credit problems.

Political solutions may defer pain, but any longer term benefits accrue to the elite. That is truer now than ever before.

The bailouts, blanket guarantees and money printing are raising the values of financial assets and thereby redistributing wealth from the poor to the rich. That’s not only creating significant ill will, but also digging us ever deeper into the hole.

We can’t borrow our way out.

Leigh Skene is an independent economic consultant specialising in financial markets. He is the author of four books, and since becoming a Lombard Street Associate in 2005 he has published a significant body of work on the credit crisis, predicting its impact and progress.

His latest work, The Impoverishment of Nations, has been published by Profile Books. It prescribes a radically different solution to the challenges created by the credit crisis, outlining a plan to overcome the inherent flaws in the global monetary system as we prepare for a very different economic future.

Article originally publised in Issue 18 (Winter 2009-2010) of the Channel Islands Stock Exchange Bulletin Board magazine

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