Montrose Journal Summer 12

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The financial crisis has placed a huge strain on public finances around the world. Deficits have exploded and government borrowing in many developed countries has soared to levels unknown since the Second World War.

Dealing with this presents an enormous challenge. In their book about the perils of public debt crises, the American economists Kenneth Rogoff and Carmen Reinhart pointed out that high levels of government debt are associated with low growth and high inflation.

Once bondholders lose confidence in the ability of states to repay debts, they can quickly take flight. The eurozone has experienced a series of runs in the past three years, starting with Greece at the end of 2009, and five member countries have now been forced from the public markets. This is threatening to spread beyond the small peripheral states into large systemic countries, such as Spain and Italy: a serious escalation. Italy has the third largest stock of public debt in the world.

But the problem of excessive borrowing extends beyond the stock of government debt. The entire developed world has overleveraged. "In the past forty years, the world has been more successful at creating claims on wealth than it has at creating wealth itself," Philip Coggan, the financial editor of the Economist, wrote in his recent book, Paper Promises.

Unfortunately, this build-up seems to have peaked just as the economic outlook for some countries – especially in Europe – is worsening thanks to a mixture of poor demographics and rising energy costs.

Facing falls in the number of workers relative to dependent pensioners, the ability of these countries to offset a dwindling labour force by increasing productivity is being undercut by higher energy costs. This is due both to greater competition for resources and poor policy choices.

The accretion of financial claims is in part the consequence of a series of policies adopted – principally in the 1970s and the 1980s. On a macro level these saw the adoption of floating exchange rates and the dismantlement of capital controls. These steps removed any practical restriction on the creation of paper money other than the maintenance of public confidence.

Combined with a parallel move to liberalise the workings of the financial sector, this unleashed the conditions for a rapid and dramatic build up of debt. While western economies have grown, asset prices have risen faster and debts have risen faster still.

There has been a super-sizing of the financial sector, especially in economies such as the US and the UK, and this process has in turn arguably weakened the productive sector of the economy. As the Nobel laureate James Tobin warned in 1984: "We are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards relative to their social utility."

As the recent scandals surrounding the Libor interest rate and the peddling of unnecessary derivatives to smaller companies suggest, bankers have not always been scrupulous in their pursuit of profit. While many of the financial products developed in recent years have been extremely profitable for the vendors, many are also, in the memorable phrase of Lord Turner, chairman of the Financial Services Authority: "socially useless."

Jean-Louis Arcand, Ugo Panizza and Enrico Berkes have argued in a recent paper for the International Monetary Fund that large financial sectors and excessive private credit can for these reasons curb economic growth. In particular, they suggest that finance starts having a negative effect on output growth when credit to the private sector surpasses 100 per cent of gross domestic product.

Given all these unhelpful dynamics, then, it is quite possible that borrowers have made promises that they will ultimately be unable to fulfil. The Eurozone may just be a financial canary in the coalmine, experiencing just the first few of a number of debt crises that are set to break around the world.

The numbers make for uncomfortable reading. Heading a list of fiscal deadbeats is Japan with gross public debts of 229 per cent of GDP. It is followed by Greece (160 per cent), Italy (120 per cent), and the US (103 per cent). All are above the 90 per cent point at which Rogoff and Reinhart claim that economic sclerosis kicks in.

Worse, these figures ignore contingent liabilities such as healthcare and pensions. The OECD reckons that such unfunded liabilities are 150 per cent of GDP in Japan and 130 per cent in Italy. Without big changes in fiscal policy and age-related spending then, already overblown ratios will soar still further.

Public debt, of course, is only part of the problem. Households have leveraged to buy consumer goods and housing – a process facilitated by financial liberalisation. Moreover, as the crisis has deepened and the private sector has sought to cut its borrowings, a game of financial pass-the-parcel has started with debts being shuffled across via banks into the hands of the public sector.

In the UK, for instance, direct financial guarantees to the financial sector alone amounted to roughly 50 per cent of GDP. The European bailout packages can be seen as the next stage in this game – where debts pass from weak governments to strong ones. The final stage – which the Eurozone is still working out in its debates about banking and fiscal union – is how much of those debts the strong governments are ultimately willing to absorb.

The idea that public debts are 'risk free' is a modern conceit. Governments have defaulted on loans for as long as people have been willing to lend to them. As Rogoff and Reinhart pointed out, Greece has been in default for roughly half of the 183 years since it became an independent state.

As late as the 18th century, mistrust in the fundamental creditworthiness of sovereigns remained strong. Adam Smith believed that when "national debts have once been accumulated to a certain a degree, there is scarce, I believe, a single instance of their having been fairly and completely paid."

Not all governments, of course, dishonoured their promises. Although the British state had public debts worth 250 per cent of GDP at the end of the Napoleonic wars, it not only avoided default but steadily reduced debt levels as a percentage of output over the rest of the 19th century.

But this took place in a pre-democratic age when parliament was filled with rentiers, and the narrow suffrage made it easier to impose tough deflationary policies and ride out the consequences (one of which was the Manchester demonstration that culminated in the Peterloo massacre in 1819).

True, countries have in more recent times hauled themselves back from the brink of default without resorting to default or inflation. In the 1990s, Sweden, Finland and Canada succeeded in cutting their public debts from high levels. Sweden, for instance, saw its government debt balloon to 78 per cent after a banking crisis in the early 1990s. It has since more than halved.

But these idiosyncratic cases involved relatively small open economies, and were played out against a backdrop of rising global trade and prosperity. Conditions are very different today.

One reason for this is the build-up of the so-called global imbalances over the past quarter century. This has seen an inversion of the classic relationship between the developed and developing worlds. In the past, defaults occurred in developing rather than developed economies – generally because wealthy countries extended too much credit to emerging states.

In the years before the crunch, however, emerging countries ran up huge surpluses to developed nations. These surpluses were then recycled back to borrowers in those developed countries where they were used to finance purchases of ever more goods.

These imbalances must inevitably lead ultimately to contraction when they are finally unwound. As the US economist, Richard Duncan, has explained, western consumers who have been buying goods on credit must in the end retrench simply because at some point they will no longer be able to afford to continue. When this happens, the Asian producers who have expanded production to service western demand, will be stuck with excess capacity, in turn leading them to cut prices. The cumulative effect must be to reduce rates of growth around the world.

Households now appear to have reached their limits in the western world and a process of retrenchment is underway. As they repay their debts, what is unfolding is a very perilous contraction of the financial sector.

The trouble with deleveraging is that it can easily feed on itself: it is the reverse of leverage – the agreeable phenomenon that we enjoyed during a quarter century of debt accretion.

When debt levels are rising, people pay more for houses because the bank is willing to lend more against them. The value of housing then rises, giving the bank the confidence to lend more which in turn is used for other purposes, such as purchasing consumer goods or a new car. Individually these transactions may be small beer, but multiplied across the whole economy, they have a big impact. Asset prices rise and GDP growth is high.

In a deleveraging world, all of this goes into reverse. Imagine that a bank has made losses on some bad property loans. Its bosses - or the regulators, if they are in the loop - may call for it to increase its capital ratios. This means the bank can make fewer loans for the same amount of capital. This then forces some borrowers to sell assets and asset prices fall. That undermines the value of the collateral that the bank is holding. More loans are called in, leading more borrowers to sell assets and so on.

In extremis, this leads to the problem identified by the US economist Irving Fisher in which "each dollar of debt unpaid becomes a bigger dollar" because "the liquidation of debts cannot keep up with the fall in prices it causes."

Politics have conspired to make this financial restructuring more protracted and delicate. Western governments, by and large, took the decision during the crisis to protect bank creditors against the consequence of their reckless lending. They felt – perhaps understandably given the sheer scale of the bubble – that the alternative was worse. But this reluctance to contemplate writedowns of creditors, and the willingness of politicians to throw taxpayers into the financial breach, has led to several consequences.

Left with life-threatening quantities of impaired assets on their balance sheets, banks have responded rationally by tucking them away and holding out for a recovery in their value.

This slows the process of adjustment, perpetuates mistrust in banks' creditworthiness and makes it harder for them to perform their key social role of lending to the real economy. Central banks have had to be deployed - faute de mieux - to finance the groaning balance sheets of the banks.

In Europe, the ECB has lent trillions to the banking sector through a series of official programmes. The problem with this collateralised lending is that while it props up the banks, and prevents a deleveraging spiral, it steadily subordinates private lenders, making them ever more reluctant to lend without explicit government guarantees. The ultimate result is the creation of a host of zombie banks. Far from restoring private sector discipline to the banking sector, the private sector is ultimately driven out. Banks and sovereigns are left locked in a potentially lethal embrace.

The interaction between the crisis in the developed world and the international monetary system is what makes the situation especially perilous. While individual countries like Sweden could recover from past debt crises because demand elsewhere was strong, this is not the case now.

The closest parallel is perhaps with the international crisis that followed the First World War. This too was caused by imbalances; in that case those built up during the conflict by warring European nations that ran massive trade deficits with the US.

Having built up a huge advantage, the Americans were unwilling to reduce their surpluses, instead forcing the Europeans to cut wages hard to restore their competitiveness (essentially what Germany is now willing on its Eurozone partners). When the world fell into depression at the end of the 1920s, the tensions ruptured the prevailing international trading order—built on the gold standard. Relations descended into an undeclared war of competitive devaluations and tariff increases.

The persistence of imbalances, broken financial system and poor demography in the developed nations makes a happy exit from the crisis harder to achieve. As a result, we face a long period of sub-par demand.

For governments to run primary surpluses when growth is anaemic must require considerably higher taxes or less public spending – or a combination of both. Yet there is little discernable public appetite for such belt-tightening.

Since the fourth century BC, when Dionysus of Syracuse became the first ruler in recorded history to debase his coinage to reduce his debts, many nations faced with the choice between inflation and default have chosen the former. The British economist John Maynard Keynes called inflation "nature's remedy, which comes into operation when the body politic has shrunk from curing itself."

One of the reasons why the Eurozone faces a particularly perilous future is that its constituent members have all agreed to issue debts in a currency that none of them controls – and that they cannot therefore individually debase. But other nations face no such barrier.

In 2002, Ben Bernanke, now Governor of the US Federal Reserve, gave an uncompromising speech in which he declared America's determination to resist deflation. "The US government has a technology, called a printing press (or today its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, or even by threatening credibly to do so, the US government can also reduce the value of the dollar in terms of goods and services, which is equivalent to raising the prices in dollars of these goods and services," he said.

Since the financial crisis, there has been much talk of the need for a grand rebalancing of the global economy, that would involve creditors spending more to help the debtors pay down their debts. But the existing monetary order – based on floating exchange rates in the developed world and managed rates in the developing economies – makes this extremely difficult to pull off. According to Goldman Sachs, the emerging economies would need to revalue their currencies by about 20 per cent to promote the sort of rebalancing the world needs. The likelihood of this happening seems remote. But without a rebalancing, there is a risk that international tensions will rise. Already some developing countries are claiming that the crisis-management tools deployed by some western countries, such as quantitative easing, are simply a cover for currency debasement. Some emerging countries, such as Brazil, fume about "currency wars".

There is no easy answer to the problem. Changing the international monetary system to return to gold, for instance, is perhaps beyond reach. But some change to the international trading order must be attempted if inflation and competitive devaluations are to be avoided. Some ideas have been tentatively tabled. In 2010, Tim Geithner, the US Treasury Secretary, proposed the idea of countries agreeing to limit their current account surpluses to four per cent of GDP. Capital controls may need to be re-imposed. But there are big barriers to any putative agreement. China would be reluctant to sanction anything that might result in losses on its holdings of US treasuries. By the same token, the US would resist any reform that curbed its budgetary freedom or its ability to denominate its international obligations in its domestic currency.

The objective, therefore, must be to encourage Asian nations to wean themselves off the need to insure against economic insecurity by piling up foreign reserves. Any reform needs to encompass fairly far reaching changes to the International Monetary Fund, and be designed to give the Asian states confidence that they can run deficits without attracting attacks on their currencies. It will take imagination on all sides to find a way through.

Jonathan Ford is chief leader writer for the Financial Times

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