As with all debt deflations, the aims of government and the private sector are now in fundamental conflict.
After years of too much borrowing and spending, people now just want to save as governments try to get them to borrow and spend.
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Banks want to conserve capital, as policymakers try to make them resume lending.
And at the risk of oversimplifying a complex set of relationships, and pricking the current bubble of expectations around fiscal and monetary policy, the public sector is too small relative to the private sector to do much about it.
As often happens, the problem is best summed up by a joke.
The satirical website, The Onion, reported the other day, tongue firmly in cheek:
“A panel of top business leaders testified before Congress about the worsening recession Monday, demanding the Government provide Americans with a new irresponsible and largely illusory economic bubble in which to invest.
‘What America needs right now is not more talk and long-term strategy, but a concrete way to create more imaginary wealth in the very immediate future,’ said Thomas Jenkins, CFO of the Boston-area Jenkins Financial Group, a bubble-based investment firm. ‘We are in a crisis, and that crisis demands an unviable short-term solution.’
There’s a bubble in government bonds, of course, but they’re all owned by China so that doesn’t count.
In the absence of a decent illusory asset bubble, wealth must be rebuilt the old-fashioned way – by saving.
The Australian Treasury yesterday released the latest reading on private sector wealth from its “modellers database”. It showed that per capita wealth in Australia stood at $231,000 at the end of September, down 7.8% over the previous year.
CommSec’s economists reported that in real terms wealth declined 3.2% in the September quarter and 10% over the year – the biggest decline on record (that is, since 1960, although it could be longer; they just don’t know).
We know, by the way, that wealth declined further in the December quarter because both shares and property values fell – we just won’t know by how much for another three months.
We know that debt as a percentage of household income and GDP is at a record level in most western countries, including Australia.
Debt deflation occurs when the collateral for a loan decreases in value while the value of the loan remains the same. On an economy-wide basis, it occurs as a result of extreme over-indebtedness associated with an asset bubble.
The world is now in the grip of a massive debt deflation that is destroying wealth on an unprecedented scale.
It’s unprecedented for three reasons – there wasn’t just one bubble, but a series of them; debt has never been this high; and for the past five years or more the debt has been irresponsibly loaned and financed (credit standards have declined and the loans were securitised and turned into “derivatives”).
As a result there is little or no chance that principal and interest in much of the world will be repaid.
Remember that although the market value of debt securities has declined and banks are creating big provisions against loan losses, resulting in huge bank losses and a credit crunch, the loans themselves remain the same.
That is, the $1 million mortgage might now be in the bank’s books at $500,000 because that’s its market value or because of provisions against loss, but the borrower still has a debt of $1 million. Meanwhile the borrower’s assets have also declined, whether it’s property, shares, motor vehicle, plant and equipment or a business – they’re all down.
So both the borrower and the lender are underwater and drowning. In each case their only two options are to default or to knuckle down and ride it out by saving and conserving capital.
This is not a quick process.
In its latest quarterly review for clients, the Texas-based firm Hoisington Investment Management, wrote that “in the world’s three most recent debt deflations – the US from the 1870s to 1890s, the US from the 1920s to the 1940s and Japan from the 1980s to the very present – the low in long term interest rates occurred about 15 years after the end of the debt mania.
“Even 20 years after the end of the debt boom, interest rates were not much above their yearly average lows.”
The principle of the firm, Van Hoisington, writes: “Our judgement is that the power of monetary policy revolves around the ability to initiate a new borrowing and lending cycle. This can only happen if lenders are willing to lend and borrowers are wanting [sic] and able to borrow. Presently, neither are so inclined.”
The reverse applied during the bubbles. Lenders and borrowers were very inclined indeed to do their thing because there was money to be made from rising asset prices. High and rising interest rates made no difference to this inclination.
Now official interest rates are at, or near, zero in many countries, but actual borrowing rates remain very high because lenders are demanding much higher risk spreads.
And even if they weren’t, borrowers would be out of the market, intent on rebuilding their balance sheets.
But monetary policy is already passé – so 2008; the discussion now is all about fiscal policy. What will Rudd/Obama/Brown/Merkel etc do to turn the economy around and save jobs?
One of their problems is that the public sector is now much smaller than it was – around 20% of GDP. The real economic power of politicians, especially that of Barack Obama, is vastly inflated by their media profiles and their claims to omnipotence to buttress their voter appeal.
When is the last time you saw a head of state shrug his/her shoulders and say “sorry, there’s nothing I can do”?
What can they do? Basically, cut taxes or increase spending. Much of the former is wasted as a generator of jobs because it is saved, not spent, and the latter must be financed either by increased taxes or government borrowing.
Obviously increased taxes are out of the question, so governments must borrow money that would otherwise go to the private sector, while paying lower interest because of their sovereign credit ratings (which derive from the ability to forcibly tax their citizens to service the debt).
Another problem is that federal government spending is offset by state and local government cutbacks.
Around the world, and including in Australia, states and municipal councils (especially those that invested in debt derivatives) are running into large deficits that they have no way of financing.
Reduced income from real estate stamp duties, payroll taxes, gambling taxes and so on must be matched by spending reductions.
That’s not to say there is nothing the federal government can do to prevent massive unemployment and long-term misery, just that expectations should not be high.
Specifically the idea of a permanent late 2009 recovery based on fiscal and monetary policy measures is a fantasy – unless, of course, a new asset bubble can be found.
Back to The Onion for the last word:
“Current bubbles being considered include the handheld electronics bubble, the undersea-mining-rights bubble, and the decorative office-plant bubble. Additional options include speculative trading in fairy dust – which lobbyists point out has the advantage of being an entirely imaginary commodity to begin with – and a bubble based around a hypothetical, to-be-determined product called ‘widgets’.
‘Every American family deserves a false sense of security,’ said Chris Reppto, a risk analyst for Citigroup in New York. ‘Once we have a bubble to provide a fragile foundation, we can begin building pyramid scheme on top of pyramid scheme, and before we know it, the financial situation will return to normal.’”
This article first appeared on Business Spectator