Posted by:
Andrew Bell

27 May 2010

When the public sector takes on part of the burden of private sector debts, it is not some detached entity swooping in to bail out the economy. The public sector is funded by today’s and tomorrow’s private sector so people are being bailed out using their own and their children’s money. What the bailouts do is to buy time for an orderly workout. Far from being painless, this is likely to include a spectrum of events including defaults, weakened growth arising from money being diverted to service and repay debt rather than new debt being taken on to boost growth, and a transfer of wealth and income from the owners of money to borrowers. The world has belatedly recognised that the public underpinning of some of the private sector’s debts did not reduce the debt at all. Indeed, the imperative to use fiscal policy to prevent an economic slump has increased the debt problem, as a by-product of the successful stabilisation of confidence. Central banks eager to reverse the extraordinary monetary assistance to markets will have to wait until the debt overhang is on the wane, not simply changed ownership. The Euro-chaos is a reminder that this workout will be uneven and lengthy. Making Germany realise this reportedly required France to threaten to leave the Euro during early May.

Two things spell doom for debtors – impossible mathematics and lack of will. Greece has demonstrated both but both factors look less severe for other economies. As the US economist Herb Stein once said, if something is unsustainable, one day it will stop. If debt is so large relative to income that it is effectively impossible to get on top of the servicing burden and pay back capital, the debt will not all be repaid. What was true for some sub-prime borrowers and overleveraged companies is also true for countries. The current crisis of confidence over European sovereign debt is because investors do not know where the line will be drawn and perceive an incoherence in the region’s economic policy – the currency union makes it impossible for a country to restore its trading competitiveness by devaluing, yet there is an unwillingness to give weaker economies the unconditional support that would enable them to borrow at rates that would make their debt manageable (at least for most of them). Europe’s trillion dollar package was supposed to show that the Euro-zone would do what it takes to hold the currency union together and stand by its economic laggards. The “feta complis” has come a cropper (lis), since the scale of the Euro’s financial package has been matched by disunity and hesitation in implementing it. Is it intended to be a rescue or a punishment? Both might be warranted but one has to take priority. In a crisis, the key objective is to surmount the crisis so that it does not spread.

It is said that it is pointless to run away from a bear but this does not make donning running shoes fruitless if by doing so you can ensure other trekkers are caught first. The US and UK bond markets are trading at yields that offer minimal protection against the longer run inflation risks but, having authorities with a clearer focus on generating growth (whether by devaluation, printing money or fiscal pump-priming, until now) they are seen as safe havens, attracting flows of money out of the Euro-zone’s troubled and quarrelsome markets. If these are safe havens to preserve wealth beyond the immediate volatility, then Caligula was a social worker.

The key to managing public deficits is for the nominal size of the economy to grow faster than the national debt (arising both from the interest cost of servicing existing borrowings and the new debt to fund deficits). In 2009, developed economies shrank in both real and nominal terms, so heightened budget deficits rapidly increased the size of national debts relative to the size of the economy. In 2010, moderate growth and some inflation have nudged growth ahead of debt servicing costs raising the prospect that together with a cyclical improvement in budget deficits (as people pay more taxes) governments with credibility will start to get on top of their fiscal problems. The problem is for those in the middle, where credibility is stretched, especially as many of these are in the Euro-zone which, until recently had an uncompetitive currency and a central bank with a seemingly McCarthyite obsession about inflation.

It is the nature of financial markets to “discover” known risks and imbue them with the status of cures for old age or baldness. Problems that were overlooked a few months ago when the “new news” was that growth was faster than expected now attract negative attention to the exclusion of continuing (but now old hat) news about economic and profit recovery. As ever, there are more people negative about equity markets trading at levels 10-15% lower than a few weeks ago than there were when prices were higher and sentiment was benign.

Whilst it is possible that this somewhat prolonged crisis will be mishandled in a way that damages the European banking system and seriously wounds the world’s nascent economic recovery, this seems a worry rather than a probability. Unlike the sub-prime crisis and the revelations about the extent of leverage in the financial system in 2008, this Euro-zone sovereign debt crisis does not come out of a clear sky. The ECB seems to have accepted that it will have to lend its credibility to some of the flakier European sovereign borrowers for the greater good.  Equity markets are materially cheaper than a month ago, in many cases yielding more than government bonds (often a buy signal in the past). The Euro’s plunge has both boosted the competitiveness of European companies and reduced their price for external investors – reasons to be more positive on them, not less. The world’s monetary and government authorities who in 2009 recognised that growth and the restoration of confidence were the best chance of achieving an orderly deleveraging of the world economy are unlikely to have forgotten the difficulty of stabilising the panic of 2008. It seems likely that the monetary accelerator will be turned back on, even if the fiscal brake has to be applied to restore the bond vigilantes’ faith in government paper.

It often takes a financial crisis to make the unpalatable seem preferable to the unmanageable. Governments will therefore now have to take more rapid steps towards fiscal stability and monetary policy will have to be proactively used as a temperature stabiliser for the economy. After recent falls, this seems to reinforce the relative case for real assets such as equities (which have become cheaper) compared with government bonds (which in the UK, the US and Germany at least have become more expensive).

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