Big trouble ahead (posted by Leith van Onselen)

Back in May, former Reserve Bank of New Zealand advisor, Terry “Macca” McFadgen, wrote a guest post on MacroBusiness entitled: Will Aussie housing go bust?

Now Terry is back with another serving of ‘Maccanomics’. In this installment, Terry provides a sobering assessment of the global economy, and maps-out how events might unfold. This is a must read article. Enjoy!

——————————————————————————————————————————————-

Macca was struck by a short piece in a newspaper last weekend titled “Pessimism is The New Black”. The theme was that the wave of pessimism hitting global markets was a bit like a fashion trend: no real rationale, just an inexplicable thing of the moment that would soon morph into something more congenial.

Sadly that is not the case. The underlying structural weaknesses that are roiling markets aren’t a fashion and they are not going to go away any time soon. Here’s a more sober assessment from the guy who is probably the highest paid fund manger in the world (Mo El Erian, CEO at PIMCO, formerly manager of Harvard’s $30b plus endowment):

“The world economy is now in the grips of a damaging feedback loop involving deteriorating fundamentals, lagging policy responses and destabilized financial markets. If policymakers do not act boldly, and do so in a globally coordinated fashion, the world risks slipping into a prolonged recession with worrisome institutional, political and social consequences”.[1]

As befits a former IMF economist, he minces his words. Unless something changes quite dramatically there will surely not be any bold, globally coordinated action and a prolonged global recession or near recession will follow this failure. That is now Macca’s central case.

What’s gone wrong?

Just about everything:

• US growth data has been ugly. First and second quarter growth looked quite promising but data revisions have pulled that back and for the last six months growth has averaged a little less than 1% annualized. At this level no new jobs can be created and the 15m odd Americans looking for work will grow in number as new entrants join the workforce. Worse still, the American economy is going to have to cope with a fiscal contraction next year of about 2% of GDP as stimulus measures like payroll tax relief expire this December. A recession or near recession in the USA is pretty much guaranteed for 2012 in the absence of a new cross party stimulus deal. The media will focus on the “R” word-but it’s irrelevant whether growth is slightly negative or slightly positive. The USA needs strong growth to escape its current predicament and that is just not going to happen next year.

•  US house prices continue to weaken a little and the 25% or so of households under water are running out of air. These families cannot move location even if they could find jobs elsewhere. The world’s largest economy is facing a future in which high unemployment will become structural as skills fade and motivation is destroyed. The social consequences- alluded to in passing by El Erian in the paragraph above but of huge importance- will potentially be nasty. The UK riots are a warm up.

• The US debt ceiling shambles has destroyed investor and business confidence in the ability of the US political elite to manage the country sensibly. Don’t expect businesses to invest or start hiring in this climate. Would you? Sadly, business is the one sector that has cash ready to spend given that households and the Government sector are both in lockdown mode. The best lifeline for the US economy has now been cut by inane political games. As I write, US 10 year Treasury yields have hit their lowest level in 60 years.

• The European Monetary Union is a shambles, and a debt -death spiral (where rising interest rates force austerity measures which cut tax revenues which results in expanding fiscal deficits which pushes up rates once more) now threatens economies of real size and importance-Spain, Italy and France. They have responded with panic measures designed to cut fiscal deficits in the hope that bond markets will remain open at attractive rates. But as they all do the fiscal squeeze together, European demand is going to contract. Europe needs growth, not panic driven austerity. This week’s GDP data for the E.U was terrible and the Union now stands on the edge of a recession.

• A partial break up of the Euro-zone is now Macca’s central case. This sees the weakest of the Club Med members being forced out (Greece and Portugal-maybe Ireland or even Italy) or the rich north (Germany, the Benelux countries, Austria and Finland) cutting themselves loose. It is a case of “choose your poison”. If the weak are forced out, a lot of German and French banks are going to have to be recapitalized to cope with the consequent write- downs in the value of bond holdings. If the rich north departs, then their new currency will appreciate rapidly and the north will end up in recession, at least for a period, as its exports get hammered.

• Which takes us to China where inflation continues to rage out of control and no meaningful progress has been made towards a rebalancing of the economy away from building”bridges to nowhere”. Growth in household consumption remains non-existent thanks to policy inertia in relation to wages(suppressed), interest rates on savings(negative real rates), and social safety net initiatives(nil).The best analysis Macca has seen suggests that China GDP needs to fall by about half (i.e. to around 5% pa) to bring inflation under control. Watch out Australia under such a scenario.

All this wouldn’t be quite so frightening if there were visible solutions. But there are not.

Three overriding problems block the view of happier days:

1) Further fiscal stimulus to support the world economy over its looming slump looks a very remote prospect. Most government balance sheets are now fully extended and those that still have capacity to make a difference to the world outlook (the USA, Germany, China) face high political barriers or other constraints.

2) The break up of the Euro-Zone now seems the most likely scenario and, as noted above this only offers lose/lose outcomes the scale of which is uncertain but surely very large.

3) Increasingly, the focus of investors and policymakers is turning to the underlying problem which is that the world faces a shortage of final demand. This is structural, not cyclical[2]. Successive attempts since 2000 to reflate economies with “money dumps” have failed. The latest round of QE dollars simply went into asset speculation or bank reserves. Commodity prices rose (including oil which ironically bit the hand that fed it), and so did stocks. The real economy did nothing. No new lending, no new jobs, no signs of life. The Fed may still be forced into QE3-but they will not do so with any conviction that the real economy will respond in the short term. The objective will be inflation and further USD devaluation (upon which I comment below.)

So the big picture is that of a shrinking or static world economy, a developed world with no gunpowder left in the fiscal or monetary magazines and deep structural issues which remain unresolved. Professor Joseph Stiglitz recently summarized all this as follows:

All of this [gridlock politics in the USA, excessive austerity in Europe] makes it likely the North Atlantic will enter a double dip, but there is nothing magic about the number zero. The critical growth rate is that which stops the jobs deficit getting larger. Problematically, America’s and Europe’s current growth rate of about 1% is less than half the amount required to do this.

When the recession began there were many wise words about having learnt the lessons of both the Great Depression and Japans long malaise. Now we know that we didn’t learn a thing. Our stimulus was too weak, too short and not well designed. The banks weren’t forced to return to lending. Our leaders tried papering over the economy’s weaknesses – perhaps out of fear that if we were honest about them already fragile confidence would erode. But that was a gamble we have now lost.

Now the scale of the problem is apparent, a new confidence has emerged: confidence that matters will get worse, whatever action we take. A long malaise now seems like the optimistic scenario”[3]

Pause for stiff drink here if you wish. Indeed Macca himself had to do so.

How all this will resolve itself is unclear. But three decisions are going to be critical:

1. Will Germany Fold its Cards and Guarantee all the Bills?
2. Will The Fed Inflate US Debt Away?
3. Can A Grand Bargain Be Struck?

1. Germany’s Big Decision

The crisis in the Euro-zone could be solved overnight by Germany guaranteeing the rest of its members either by permitting the issue of Eurobonds backed by the EU as a whole (jointly and severally), or by greatly expanding the EU Emergency Support Fund. Germany’s credit is vast and unquestioned.

But the obstacles are many. For a start ,Germany would not even contemplate such a move without having a high level of permanent control over the budgets of all EU members-a perfectly reasonable requirement. (Would you dear reader want to be guaranteeing Berlusconi or the serial fiscal criminals in Greece, or for that matter the Spaniards with youth unemployment at 40%?).

How would such control be exerted in institutional terms? Does Germany really want that responsibility and how could the transfer of sovereignty possibly be sold to the rest of the EZ populace? The institutions are not in place to take such control, nor does the EZ populace understand the issues. Treaty amendments would be required as a minimum, and probably referenda. In 10-20 years that might be attainable-but today it seems a massive stretch, even under the threat of immediate insolvency in the Club Med.

But the alternative – a break up of the EZ – seems equally unpalatable. Unfortunately it is the default option and the smart money is backing it.

Maybe when we reach one minute to midnight Germany will blink and it will take control of Europe in exchange for its balance sheet. It’s an horrific decision for the German people. My guess – I stress guess – is Germany will not do so because the institutional and constitutional issues are too intractable. So the EZ will struggle on, hoping vainly for a change of market sentiment until it collapses some time next year. What then happens to the wider EU project is very unclear.

Macca wishes it were otherwise because the Euro has been a magnificent – albeit flawed-experiment and the social and political consequences of break up will be with us for decades. Let me offer some final words on this subject from Jeremy Warner, The Daily Telegraph’s economics writer:

“Watching Angela Merkel and Nicholas Sarkozy at their press conference on Tuesday [August23], it was clear that the two are still a million miles away from recognizing the enormity of the choices their nations face-and that the crisis will have to escalate at least a couple of notches before they will even consider the solutions that are required…

The truth is that a project meant to tame Germany and integrate her into the heart of Europe has backfired spectacularly. Far from making economies converge, it has succeeded only in driving them ever apart. From Britain’s island haven, we can only look on in horror as Europe once again stares into the abyss”[4]

British hubris aside, it is hard to disagree.

2. Will The Fed Inflate US Debt Away?

Unlike most other central banks, the Federal Reserve has a dual mandate-to maximize employment and to control inflation. The inflation target has never been formally stated, but like most central banks we can assume it is under but very close to 2% pa.

As long as around 25% of US households with mortgages are under water there will be no employment growth and deflation will be a constant threat. The household mortgage problem could (and should) be solved by fiscal initiatives (e.g. debt for equity swaps offered by the Federal Government), but these routes are almost certainly closed by Washington’s political paralysis.

So what should the Federal Reserve do to meet its mandate? Arguably it should (indeed must) encourage a period of above target inflation. Assume a household with a debt to house value ratio of 100%. Assume also inflation of 4.5% pa for five years. Assisted a little by the power of compounding, the ratio has improved to 80% by year five which is starting to look much more manageable. Household consumption is revived, employment grows, problem solved.

In reality such an approach would involve a massive value transfer from savers (whose savings are devalued) to borrowers (whose debts are being massaged down). The victims of this transfer would be a mixed bunch. Boomers would suffer but so would the Chinese, Japanese and Petro-zone countries all of whom are major lenders to the USA. The USD would be hammered and US yields would come under upwards pressure in the absence of massive QE to force them down.

But massive QE would be required anyway to get inflation going at a good clip. So stand by for QE3-probably after the joint congressional committee has reported on its savings proposal and there is nothing in it for homeowner relief or to ward off a 2012 recession.

Markets therefore see a high risk of US inflation/devaluation and it is not for nothing that the price of gold has doubled in a couple of years, or that the Swiss Franc has gone through the roof in the last month or so.

Apart from the destabilsation of economies outside the USA via currency appreciations (not our issue says the Fed), the major problem is calibration. What additional quantity of money dumped into the financial system is sufficient to get a reasonable amount of inflation but not an avalanche? The Fed will have models which point to answers – but the models are highly uncertain. Risks abound.

The politics too is likely to be fearsome. Savers get hit and over- borrowed households get a free kick. It’s election year and a political fiasco is in prospect which would see the Fed getting dragged into the political arena. Add to that prospect a geopolitical backlash as the value of Chinese US bond holdings is trashed.

Maybe you are now thinking that gold at $2000 per once is not silly and a little place in Bluff (the remotest place on earth for those not familiar with NZ geography) might be a good idea? The rush is on for inflation proof assets but there are not many places to hide. It’s scary.

So will they do it? In my view yes-unless Washington can come up with a fiscal package to head them off, which seems highly unlikely. Stand by for QE3, inflation and further USD weakness.

3. Can A Grand Bargain Be Struck?

As long as global final demand is weak the world economy will remain mired in recession. The global”business model” of the last decade and a half was built on fast growth of household demand in the developed world fuelled by easy credit, Chinese deflation and inflating asset values, particularly housing. That model is now dead. Note that an intrinsic part of the dead system was the build up of massive current account surpluses by China and Germany in particular as they suppressed domestic demand and gorged on exports.

Where might alternative sources of demand come from? That’s easy – it can come from Chinese, German and Japanese households none of which participated in the “developed country” consumption splurge.

If those households could be mobilized to spend some of their vast savings by appropriate policy measures then world demand could be rebuilt on a basis which saw current account balances restored to neutral levels. That is, the USA would move into surpluses via exports, and China, Germany and Japan would move into much smaller surpluses and eventually into balance. Within Europe the Club Med countries would also need to rebuild export capability to balance their current accounts vis- a- vis Germany and to replace burnt out households as a demand source. This they could achieve by exiting the EZ and devaluing.

The ingredients of a grand deal would look something like this (there are many variants on this theme):

• China would take aggressive policy measures to reorientate its economy towards more household consumption and much less infrastructure investment;
• Germany and Japan would also stimulate household consumption and reduce their dependence on exports;
• Currency realignments would be agreed to support these reorientations, including those required to assist the PIIGS;
• Temporary funding support would be provided by the surplus countries (China, Germany, Japan) to facilitate the necessary economic transitions; and
• The USA would agree to limit further QE (and inflation) and would support the USD at a defined value.

Grand bargains have been struck before – for example at Bretton Woods in 1944 and in the Plaza Hotel 5^th Avenue in 1985. Will it happen again? No – not any time soon because in addition to the complex policy issues the political obstacles are overwhelming in the context of the current election cycle in the USA and the leadership transition next year in China.

Moreover, if China sees in the current situation the potential for the total breakdown in Western economic leadership, why not just watch the ship sink? That, beyond everything, is the question of the decade and maybe of our generation.

But if the Chinese can be persuaded that their interests do not lie in the direction of an implosion of the developed economies, then thereafter one might see a glimmer of hope as the world faces up to its two harsh options – either do a comprehensive deal realigning economies around available sources of demand, or face a very prolonged period of adjustment by slow degrees accompanied, one fears, by serious political upheaval.

So What?

You can slice and dice the answers to three questions above to generate a lot of different scenarios-none of them very attractive. And you can fold into the mix a wild card which is the potential for the Bi-Partisan Committee on US deficit reduction to surprise us all with an effective package delivering further short term stimulus coupled with longer term disciplines and a solution to the housing conundrum.

But viewed as a whole Macca says expect more bad news and keep your powder dry. Things probably have to get worse before they get better.

In fact there is no shortage of folk who see in this crisis the demise of liberal democracy and free market capitalism itself.[5] Macca used to scorn such predictions as rubbish but he does so no longer.

Sometimes people live through major inflection points in history without knowing it. How many Frenchmen understood that the revolution of 1789 would transform the world for centuries and how many Soviets understood that Perestroika heralded the demise of the Soviet Union?

Maybe we too are living through such a moment. The break up of the EZ-and possible end of the European project-would be bad enough, but if China decides to stay on the sidelines and dissemble, then all bets are off.

On the positive side, adversity can breed great leaders. That isn’t Obama, Merkel or Kan for sure – but maybe from left field our FDR or Thatcher will emerge. We live in hope.