The Global Financial Crises' Placebo Effects
by Satyajit Das
(Also see: When Money Becomes Worthless by Martin Hutchinson)
Botanical commentators are finding "green shoots." The astronomically minded have seen "glimmers." The meteorologically minded have spoken about the storms "abating." Strong rallies in equity and debt markets have confirmed the recovery for the "true believers." The Global Financial Crisis (GFC) crisis is over!
It is useful to remember Winston Churchill's observation after the British expeditionary force's escape from Dunkirk: "[Britain] must be very careful not to assign to this deliverance the attributes of a victory.'' There may be confusion between "stabilization'' and "recovery.''
The green-shoots theory is based on a slowdown in the rate of decline in key economic indicators, improvements in the financial system, unprecedented government support for the banking system, near-zero interest rates and large fiscal stimulus packages. The recovery of emerging markets, especially China, also underpins hopes of a swift return to growth.
Receiving the messengers
The puzzling thing is that real economy indicators continue to be poor.
GDP forecasts for 2009 have steadily deteriorated, with world growth expected to be negative 2% to 3%, with especially poor prospects for Japan and the euro zone. Industrial output, employment, consumption, investment and global trade continue to be weak. Even China, which expected to grow between 6% and 8% in 2009, experienced a fall in exports of over 20% over the last year.
The wealth effects of the GFC on economic activity are unclear. In the United States alone, $30 trillion of value has been destroyed. Pension funds have lost anywhere between 20% and 50% of their value. Combined with declines in housing prices and reduced dividends and investment income, the sharp decline in wealth may not be yet to fully flow through into consumption.
The financial system has stabilized but not returned to the "rude good health" that current executive compensation demands within banks would suggest.
Good results for Goldman Sachs and J.P.Morgan are offset by less impressive performances by Bank of America, CitiGroup and Morgan Stanley. Profitability is patchy and reliant on risky trading income and large underwriting revenues from capital raisings by financial institutions and companies who are de-leveraging aggressively. Asset quality remains vulnerable to more bad debts from the normal recessionary credit cycle that is working through the economy.
Bank risk levels have increased to and in some cases beyond pre-crisis levels. Goldman Sachs second-quarter earnings showed an increase in risk levels as measured by Value-at-Risk (VAR). The increase in risk is probably understated as it takes into account diversification benefits that may be overstated under conditions of market stress. It is probably also understated because of assumption of trading liquidity that may be optimistic given recent experience. The higher levels of risk-taking reflect increasing comfort in central bank support of financial institutions' liquidity and their ability and willingness to intervene to limit price risks. Leverage and lending against risky assets has resumed at a rate not seen since 2007.
Capital remains scarce and bank balance sheets are at best not growing and at worst shrinking. Some estimates suggest that the bank capital shortfall could be in range of $1 trillion to $2 trillion, equivalent to a credit contraction of around 20% to 30% from previous levels. Proposed bank regulations, primarily the increased levels of capital and lower permitted leverage, will also affect the ability of the financial system to extend credit.
The link between debt and economic growth is well established. The global economy probably needs around $4 to $5 of debt to create $1 of GDP growth.
International Monetary Fund researchers Tamin Bayoumi and Ola Melander, in a study of the economic impacts of an adverse shock to bank capital ("Credit Matters: Empirical Evidence on U.S. Macro-Financial Linkages," IMF Working Paper 08/169) found that in the United States, a one percentage point fall in Tier 1 risk-weighted capital ratios reduces real GDP by 1.5%. This means that global bank capital shortage may restrain credit creation thereby reducing economic activity and sustainable growth levels.
The impact of fiscal stimulus packages has been variable. In some jurisdictions, the payments have been saved or applied towards debt reduction rather than consumption. Targeted measures, such as the cash-for-clunkers' deals (cleverly packaged as ‘green' environmental initiatives) have boosted immediate demand for cars, but the long-term demand effects are unclear.
The multiplier effect of the fiscal initiatives is likely to be low. Major infrastructure initiatives will take time to implement. Few projects are "shovel ready." The rate of return on government spending programs, some of which are politically motivated, is unclear. Government spending increasing capacity is likely to create problems in a world where many industries are operating with surplus capacity. Government bailout packages for various industries, such as the auto and housing industries, however well intentioned, are delaying much needed capacity adjustments and risk prolonging the problems.
The phoenix-like recovery in emerging markets is primarily driven by panicked government spending and loose monetary policies increasing available credit. Estimates suggest that around 6% of China's growth of around 8% is attributable to government spending and increased bank lending.
The extraordinary increase in lending in China is fueling unsustainable growth. In the first half of 2009, new loans totaled more than $1 trillion. This compares to total loans for all of 2008 of around $600 billion. Current lending is running at around three times 2008 levels and at a staggering 25% of China's GDP. The combination of government spending and bank loans has resulted in sharp increases in fixed asset investments (up 30% from 2008). Government incentives, in the form of rebates for purchases of high value durables such as cars and white goods, have also increased consumption (up 15% from 2008). Even Chinese government officials have admitted that the recovery is "unbalanced."
The increase in industrial production in the absence of real end demand for products could result in a rapid inventory buildup. The availability of credit is also fueling rampant speculation in stocks, property and commodities. Estimates suggest that around 20% to 30% of new bank lending is finding it way into the stock market, in part driving up values.
The price rise in emerging market shares, debt and currencies also reflects a blind belief that anywhere must be safer and more promising than the U.S., Japan or Europe. This misses the point that these markets have a strong trading and export orientation or are external capital dependent. While some have bright long-term futures, they will need to make difficult and slow adjustments to their growth models to return to trend growth.
The recovery in emerging markets has, in turn, underpinned the recovery in commodity prices and economies dependent on natural resources. A significant part of this is inventory restocking but there is a speculative element. Availability of abundant and low-cost bank financing, combined with a deep-seated fear of the long-term prospects of U.S. Treasury bonds and the dollar, has encouraged speculative stockpiling of certain commodities, artificially boosting demand.
In reality, the global economy has, in all probability, entered a period of stability after a fairly big decline. Market sentiment seems to be shaped less by facts than the Doors' song: "I've been down for so long, it feels like up to me."
A key risk remains the ability of governments to finance their burgeoning government deficits. A wretched combination of declining tax revenues, increased government spending to cushion the economy from recession and bailout packages for banks and other "worthies" means that many countries face large and continuing budget deficits.
In August, the U.S. Congressional Budget Office released forecast that project the 10-year deficit to reach over $9 trillion, some $2 trillion more than it had estimated as recently as March 2009. Even countries with relatively healthy balance sheets such as Australia do not anticipate balancing their books for many years. If the problems of an aging population and unfunded liabilities such as public sector pensions, health-care and social security arrangements are included, then the budgetary position looks considerably worse.
In 2009, total sovereign debt issues are expected to total more than $5 trillion, of which the United States alone will need to finance around $3 trillion. The increases in sovereign debt issuance are astonishing – U.S. around 300%, U.K. over 400%, euro zone around 50%. Government debt-to-GDP ratios for many developed countries are projected to reach and remain at levels in excess of 100%.
Overall government deficits in major economies through the recession are estimated to total around $10 trillion (around 27% of GDP of these economies). The work of economists Kenneth Rogoff and Carmen Reinhart on previous recessions suggests that the deficit estimates are conservative and the amount that will need to be financed will be between $15 trillion (40% of GDP) and $33 trillion (86% of GDP).
As a comparison, the total amount of global investment assets under management, according to one estimate, is around $120 trillion. This provides some idea of the funding task ahead.
Long-term interest rates have risen sharply, reflecting supply pressures. The 30-year U.S. Treasury yield has increased by around 1.50 percentage points since the start of 2009. Maturities also have shortened, increasing the refinancing challenges ahead. Participation of central banks in the U.S. and U.K. bond markets, under their quantitative-easing mandates, has hold down interest-rate increases, creating a somewhat artificial market.
A key issue over the coming months is the continued demand for increased sovereign debt issues. China, Japan and Europe historically have been major buyers of U.S. Treasury bonds. As their own fiscal position changes and their current account surplus shrinks, the ability of these investors to absorb the increased supply is unclear. China's foreign exchange reserves are growing more slowly than before. China has continued to purchase U.S. Treasury bonds, but some purchases represent a switch from U.S. agency paper. As the United States has increased its issuance program, China's purchases are now a smaller portion of the total.
In the best case, the government debt issuance is accommodated but squeezes out other borrowers. In the worst case, governments find themselves unable to finance their deficits setting off a new stage of the GFC.
Given the size of the intervention, a key question is the timing of withdrawal of government support for the economy.
The current apparent health of the financial system owes everything to wide-ranging government support. The ability of the banks to raise equity and debt is substantially underwritten by the "too-big-to-fail" doctrine. Profitability is supported by low and, in some cases, zero cost of deposits and a sharply upward sloping yield curve that creates significant earnings from borrowing short and lending long. Withdrawal of support may expose deep-seated and unresolved problems in the financial system.
Substantial quantities of structured securities are now held by central banks either as collateral for funding arrangements or through other innovative market support mechanisms. This has substantially increased the size of central bank balance sheets in the U.S., U.K and Europe.
It is not clear how and when these "temporary" positions will be unwound. Attempts to create structures for repackaging these securities, such as the frequently touted but still to be implemented Public Private Investment Partnership (PPIP) program, have enjoyed limited success. Untimely attempts by governments to liquidate these portfolios may be disruptive to fragile markets.
These securities may have to be held to maturity (sometimes over 10 years in the case of some Asset Backed Securities (ABS) and allowed to self liquidate from the underlying cash flows. The bloated central bank balance sheets may restrict policy flexibility significantly.
Government spending has been substituted for private consumption and investment. The deficits will ultimately necessitate a combination of increased taxation and reduced spending to correct this position.
Assume a country has government debt equal to 100% of its GDP. Assuming an annual interest rate of 5% and a GDP growth rate of 4%, a 1% budget surplus is required to maintain debt at current levels. If the gap between interest rates and growth is greater, then the size of the required surplus is commensurately larger. In effect, it is unlikely that the present expansionary fiscal position can be sustained over a long period. The fiscal position of major economies may restrain growth.
Belief in the recovery story and sharp financial market rallies fail to recognize that little has actually changed since the GFC began. Fundamental failures have not been fully addressed.
The required reduction in debt levels has not been completed. Increases in government debt have substantially offset reductions in private sector debt.
Instead of dealing with the problem of leverage, the debt has also merely been rolled forward through a variety of clever warehousing structures and the manipulation of accounting rules.
In a system that has excessive leverage, there are only two adjustment mechanisms. The value of assets supporting the debt and income available to service the borrowing can be increased, usually by inflation. The value of the debt can be reduced through writing it down to the real value of the assets.
Governments and central banks have gambled on inflation despite its social and economic costs. In reality, inflationary pressures in the global economy are not apparent. The rebound in energy and food costs has prevented deflation. The absence of demand, excess capacity, reduced credit creation and low velocity of money circulation may mean that it is disinflation or deflation that is the problem going forward.
There is now faith-based reliance on governments' ability to rescue the economy. Intervention has helped stabilize economic activity and the financial system but it improbable that government actions alone can prevent the necessary adjustment in debt levels and growth rates.
Government's share of most developed economies is around 25% to 40% of GDP. Its role in liberal democracies is limited by the fact that is fundamentally an intermediary, not dissimilar to a bank. It derives its resources through taxation from certain sectors of the economy and redirects it to other sectors. This means that its ability to control an economy has limits in the absence of nationalization of all productive activity.
In the short run, governments can borrow or print money to augment its resources. Like all debt, it borrows from tomorrow to pay for today. Quantitative easing (the now respectable name for printing money) also has limits, unless governments are willing to risk hyper-inflation and the social dissolution of the Weimar Republic or Zimbabwe. While governments can influence an economy, they cannot completely reverse inevitable adjustments dictated by market forces.
Governments may also be impeding necessary adjustments. Rising government investment is increasing capacity in a world with stagnant demand and over-capacity in many sectors.
China's current growth is being driven by government investment that is increasing capacity, which in the absence of sufficient domestic demand may be directed to exports increasing the global supply glut. Politically and socially motivated bailouts of national champions and strategic industries mean the necessary reductions in capacity through bankruptcy and corporate failure have not been allowed to happen.
There are even signs that the financial sector is rediscovering old habits. The government and taxpayer paid for return to profitability of major financial institutions, and the return of remuneration levels to pre-crisis levels raises fundamental questions about whether any change has occurred. After the strong second-quarter earnings report for Goldman Sachs, Chief Financial Officer David Viniar told Bloomberg News that, "Our model really never changed, we've said very consistently that our business model remained the same." Despite the egregious excesses, governments seem collectively to lack the will to reform the financial system to avoid the problems of the past.
In 2007, when the U.S. housing bubble collapsed, the satirical magazine The Onion demanded that the American people be given another bubble to speculate in. Their wish now appears to have granted. Actions to stabilize the global economy seem only to have created new bubbles – in government debt and emerging markets. Government actions seem to be primarily designed to ensuring continuation of the Ponzi scheme. The only lesson learned is that no Ponzi scheme can ever be allowed to stop.
As states one familiar but anonymous saying: "Never in the history of the world has there been a situation so bad that the government can't make it worse."
There is broad agreement that a key component of the GFC was the problem of global capital imbalances. A central feature was debt-funded consumption in the United States that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit. Japan, China, Germany and the other savers funded the consumption. At its peak, the United States was absorbing about 85% of total global capital flows to fund its government and private debt.
Any lasting solution to the GFC requires this imbalance to be dealt with. The glib solution requires the United States to save more and consume less, and the savers to save less and consume more. The problems in implementing the solution are considerable.
Timothy Geithner's recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and U.S. Treasury bonds, reveals the dilemma. On the one hand, America needs the Chinese to continue and increase their purchase of U.S. government debt to finance its fiscal stimulus and bailouts. On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings. All this should also occur ideally without any major decline in the value of the dollar or U.S.
Treasury bonds or the need for China to liberalize it currency and open its capital account, allowing internationalization of the Renminbi!
A cursory look at the respective economies highlights the magnitude of the task. Consumption's contribution to U.S. GDP is 71%, while in China, it is 37%. Given that the GDP of China is around $4 trillion to $5 trillion, vs. $15 trillion for the United States, and average income in China is around 10% to 15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.
Additionally, over the last 25 years, Chinese consumption has declined from around 50% to current levels of 37%. During that same period, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American buyer, lower U.S. growth and declining consumption creates significant challenges for China.
Dealing with these global imbalances has not been a high priority in the various summits, symposiums and talk-fests that global leaders have shuttled to and from. The focus has been ‘NATO' – no action talk only. Half-hearted and unworkable proposals, such as the use of the synthetic Special Drawing Rights as reserve currency, have emerged.
Reliance on Chinese foreign currency reserves is probably misplaced. Chinese reserves, a large proportion denominated in dollars, may have limited value. They cannot be effectively liquidated or mobilized without massive losses. Increasingly strident Chinese rhetoric about the safety of their dollar assets reflects increasing panic.
In reality, China is trying desperately to switch its reserves into real assets – commodity or resource producers where foreign countries will allow. In the meantime, China continues to purchase more dollars and U.S. Treasury bond to preserve the value of existing holdings in a surreal logic. On the other side, the U.S. continues to seek to preserve the status of the dollar as the sole reserve currency in order to enable itself to finance itself. The intractable nature of this problem is evident in the frequently contradictory statements from various Chinese spokesmen regarding the official position on the dollar.
No sustainable global recovery is likely without addressing the fundamental global imbalances that lie at the heart of the GFC.
Wolfgang Münchau, writing in the Financial Times on June 14, 2009, eloquently summed up developments. "Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world."
The placebo effect is a pervasive phenomenon in medicine. A sham medical intervention may cause the patient to believe that the treatment will change his or her condition sometime causing the actual condition to improve. Conditioning, expectations and motivation all can play a role in placebo effect.
In recent times, investors, markets and governments have all come to believe in the recovery, sometimes by selective interpretation of facts to support the conclusion that they need. As T.S. Eliot observed: "Mankind cannot take too much reality."
Given reluctance or inability to deal with the real problems, it is not entirely clear whether the GFC cures are real or inert treatments. It is also not clear whether current improvements in market and economic conditions are sustainable or merely a short-term placebo effect.
Satyajit Das is a risk consultant and author of "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives" (2006, FT-Prentice Hall).