In his novella Chronicle of a Death Foretold (Crónica de Una Muerte Anunciada in the original Spanish), Gabriel Garcia Marquez commences at the end of the story gradually revealing the events leading up to a murder. The non-linear telling creates an unusual tension. With the conclusion known, only the precise steps leading to the tragedy remain unclear. The probable endgame of Europe’s debt crisis is already known – de facto mutualisation of European debt and greater integration. But the precise events leading up to it are unknown. The story is being told backward. European Problems …. Europe’s problems are well documented. Many European nations have high and, in some cases, unsustainable levels of debt, compounded by a cluster of maturities and ratings pressures. Public finances are weak. European bank have either significant exposures to the weak property sector or sovereign debt. Euro-Zone bank claims on the public sector range from 13% to 38%. Sluggish even before the crisis, Europe’s growth rates are too low to sustain current debt levels. Many European countries have uncompetitive cost structures in global terms. Following revelations of Greece’s problems in 2009, investor scrutiny of Europe’s position has increased. A number of nations have lost access to commercial sources of finance. Their cost of borrowing has increased to uneconomic levels. Greece, Ireland and Portugal have required bailouts. Spain is to receive financing to support its banking system. The European Central Bank (“ECB”) has been forced to finance nations and banks, to avoid the risk of defaults. The crisis has exposed Europe’s social compact based on government spending and welfare services that is unsustainable at current rates of growth and taxes. It has highlighted the inflexibility of single interest rate and common currency which limits policy options. It has revealed the complex inter-relationships which allow the rapid transmission of financial pressures. It has exposed the absence of institutional arrangements to deal with a crisis, because the entire framework assumed that it could not occur. European Solutions… The required policy responses have remained largely unchanged since the commencement of the crisis – reduction of debt, temporary financing for entities that have lost market access and recapitalisation of affected banks. Almost two years into the crisis, European policymakers have begun to address each of these areas. Reduction of debt can be achieved by austerity (directing revenues to the repayment of debt) or debt restructuring (voluntary write offs or default). Austerity measures are enshrined in the Fiscal Stability and Growth Pact which requires Euro-Zone members to reduce budget deficits to less than 3% in any one year and a debt to Gross Domestic Product (“GDP”) ratio no larger than 60%. The European Union (“EU”) has undertaken a debt restructuring for Greece, euphemistically known as PSI (Private Sector Involvement), writing off Euro 100 billion of debt. In November 2012, the EU was reluctant to allow further write downs to provide additional debt relief to Greece. With 60-70% of Greek debt now held by official agencies (governments, the ECB, European bailout funds and the International Monetary Fund (“IMF”)), recognition of losses was politically difficult. Instead, a debt buyback (that handed hedge funds a large profit) and lower coupons and longer maturities on existing debt was used to reduce debt. The fiction of zero coupon perpetual Greek debt allowed Chancellor Angela Merkel to honour her promise that Germans would not suffer any losses from the bailout. There is resistance to similar debt relief for other countries, as Greece is different. The EU, ECB and IMF have collaborated to provide liquidity support and lower borrowing rates for weaker countries. Facilities include the bailout funds – the EFSF (European Financial Stability facility) which is to be replaced by the ESM (European Stability Mechanism). The ECB has the ELA (Emergency Liquidity Arrangement), LTRO (Long Term Refinancing Operations), the SMP (Securities Market Program) and its new OMT (Outright Monetary Transactions) facility. The EU has agreed the concept of a banking “union”. European bureaucrats seem afflicted by acronomania – the belief that a suitable sequence of letters can solve any problem. Unfortunately, the response is inadequate. Austerity debt is self-defeating. Cuts in spending and increases in taxes lead to contracting economic activity, increasing the budget deficit and debt. Additional austerity merely exacerbates a vicious negative feedback loop as the economy becomes mired in a deep recession with rising unemployment. Writing off the debt results in large losses to banks and investors. This requires government support to maintain the integrity of the payment and financial system, increasing budget deficits and debt. Debt relief is complicated by the fact that the claims are cross border. A large proportion of peripheral sovereign debt is held by banks and investors in Germany, France, Netherlands, Finland and Luxembourg. These nations are resisting write-offs, fearing destabilising their financial systems. The policies also fail to address growth and improving competitiveness. Without the option of currency devaluation, affected countries must force down costs, which exacerbates the reduction in activity. Not Enough… The EU Commission 2012 State Aid Scoreboard calculated that between October 2008 and December 2011, all 27 EU states provided banks alone with Euro 1.6 trillion in assistance (around 13% of EU GDP) for liquidity support, capital and removing impaired assets from balance sheets. Since 2011, further assistance has been provided to banks. There was additional assistance provided by the ECB and IMF to banks and nations. If these are included, then the total amount of assistance to date approaches Euro 3.5 trillion (30% of EU GDP), around Euro 7,000 for every EU citizen. But the financial resources remaining to deal with the crisis may be insufficient. The amounts available have not changed for almost two years, with little appetite for increasing commitments. The ESM has total lending capacity of around Euro 500 billion. Financial assistance agreed for Greece, Ireland and Portugal in the form of loans and guarantees is around Euro 294 billion. With around Euro 102 billion coming from the EU budget or bilateral aid to Greece, Euro 192 billion was provided by the EFSF, which will be subsumed into the ESM. Euro 100 billion has been committed to Spain for the recapitalisation of its banking sector. This leaves the ESM with available lending capacity of around Euro 208 billion. There are increasing constraints on IMF participation, augmenting the ESM. Greece, Ireland or Portugal may need further assistance, as their economies remain weak and market funding is unavailable or expensive, they may need additional funding to meet maturing debt and also finance budget deficits. Spain and Italy may need assistance programs. Spain has debt of Euro 800 billion (74% of GDP). Italy has debt of Euro 1.9 trillion (121% of GDP). Both countries have significant debt maturities in the near future. Spain has principal and interest repayment obligations of Euro 160 billion in 2013 and Euro 120 billion in 2014. The Spanish government has announced a financing program of around Euro 260 billion for 2013. Italy has principal and interest repayment obligations of Euro 350 billion in 2013 and Euro 220 billion in 2014. Capital flight from peripheral European countries is a problem. Banks in peripheral countries have lost between 10% and 20% of their deposits, reflecting concern about solvency and the risk of currency redenomination. Additional resources may be needed to finance a deposit insurance scheme to halt capital flight. Europe has total bank deposits of around Euro 8 trillion, including around Euro 6 trillion in retail deposits. Around Euro 1.5-2 trillion of these deposits are in banks in peripheral countries. An effective deposit scheme would need to cover around Euro 1-1.5 trillion of deposits, placing a large claim on available funds. Europe may need bailout facilities of at least Euro 3 trillion to be credible. Potential requirements exceed available resources. Europe’s Big Bazooka… The only other potential source of financial support is the ECB. It has already provided over Euro 1 trillion in term financing to banks through the LTRO program alone. These programs mature in late 2014 and early 2015. They may need to be increased or extended to finance the weak banking system. The ECB has purchased around Euro 210 billion in sovereign bonds under the SMP. In July 2012, the ECB announced the OMT program allowing purchase of unlimited quantities of sovereign bonds. President Mario Draghi announced that: “within our mandate, the ECB is ready to do whatever it takes to preserve the Euro”. Markets and investors have assumed that this is the “big bazooka” -an European version of quantitative easing (“QE”) and debt monetisation precedents of the US, Japan and UK. The ECB’s announcement underpinned relative stability in Europe in the second half of 2012. But the OMT program is conditional. ECB action is contingent on the relevant government formally requesting assistance and agreeing to comply with the conditions applicable to assistance from the ESM/ EFSF. Instead of avoiding market pressures, the triggering mechanism requires that financing problems of “at-risk” countries get worse before the ECB will act. ECB purchases will be confined to short or intermediate maturities. This condition is designed to make intervention similar to traditional monetary policy. It is also designed to reduce the cost of bank loans which is driven by shorter-term interest rates. The ECB can also nominate a cap on yield or the size of its purchases in advance of any intervention. There is uncertainty as to whether the ECB will relinquish its status as a preferred creditor on such purchases in the event of default or restructuring.
The OMT program revealed significant divisions within the ECB. Jens Weidmann, the head of the German Bundesbank and a former advisor to the Chancellor, opposed the measure. Other Euro-Zone members are also known to be uncomfortable. The legal basis of the OMT program remains uncertain. Article 123 of the Lisbon Treaty prohibits the ECB from directly buying national governments’ debt. Future legal challenges cannot be ruled out. Overcoming legal issues would require time consuming treaty changes, support for which is not assured. The OMT has not been activated to date. In 2008, US Treasury Secretary Hank Paulson’s argued that if everyone knows that you have a bazooka in your pocket it may not be unnecessary to use it. The ECB has gambled that the announcement that it is prepared to intervene will restore market access of peripheral borrowers and reduce the interest rate demanded by the market. The borrowing cost of weaker countries remains above sustainable levels. The true access to market remains unclear because of the activity of banks purchasing sovereign debt which can be financed with the ECB at a profit. The ECB President’s statements have been dominated by two words: “may” and “adequate”. Market analyst Carl Weinberg neatly summarised this as: “A promise to do something unspecified at some yet-to-be-determined time involving yet-to-be-invented programs and institutions, in a yet-to-be-decided way”. Dr. Draghi, anointed as the Financial Times’ 2013Person of the Year, operatically stated that the OMT program would: “And believe me, it will be enough”. Markets will undoubtedly test the ECB’s resolve. As Yogi Berra knew: “In theory there is no difference between theory and practice. In practice there is.” Stealth Integration… The scale of the problems, the inadequacy of financial resources available and political difficulties means that decisive actions to resolve the European debt crisis are unlikely. A slide into a deeper economic malaise, both for at risk countries but also stronger Euro-Zone members, is the most likely course of events. The real economy, already in recession, is likely to remain weak, with low growth and high and rising unemployment. The key influences will be austerity programs and weak global environment, including slowdowns in emerging economies. Other factors will be the continued restriction of credit as European banks restructure and shed assets. The low levels of economic activity will be particularly pronounced in the peripheral economies. The weakness will be transmitted to stronger economies, through weaker exports. Given that their largest markets are within Europe and in recession, Germany and France will also experience slowdowns. Increased financial strains from the need to support the weaker countries will also contribute to the contraction. Governments in the at-risk economies will not meet budget deficit or debt level targets. Banks will face rising bad debt losses and require capital infusions. For both sovereigns and banks, access to financial markets will remain restricted. Cost of commercial funding will remain above affordable levels. Further funding assistance may be required. Euro-Zone members remain committed to avoiding the unknown risks of a default and departure of countries from the Euro. This means that assistance will be forthcoming, although the exact form and attached conditions remains uncertain. Peripheral countries will be forced to rely on the ESM and ECB to provide funding. Unless the size of the ESM is increased, the ECB will be forced to provide financing directly and indirectly. In the indirect case, the ECB will provide cheap funds to banks to purchase government bonds which will be used as collateral for the central bank financing. The TARGET2 (“Trans-European Automated Real-time Gross Settlement Express Transfer System”) is a payment system to settle cross border funds flows between Euro-Zone countries. Before 2008, deficits of individual nations were financed by banks and investors. Since the commencement of the crisis, the absence of commercial financing has meant that central banks in stronger countries have used the TARGET2 to finance peripheral countries without access to money markets to fund trade deficits and capital flight. This process will continue. Over time, financing will become concentrated in official Euro-Zone agencies, the ECB and the TARGET2 system. Risk will shift from the peripheral countries to the core of the Euro-Zone, especially Germany and France. This reflects the reality that the stronger countries stand behind each of the support mechanisms. The ESM relies primarily on the support of four countries: Germany (27.1%), France (20.4%), Italy (17.9%) and Spain (11.9%). Market analyst Grant Williams prosaically described the other countries backing the ESM as Greece, irrelevant, doesn’t matter, don’t bother, makes no difference, who cares, somewhere near Poland, pointless, up the top, former something-or-the-other, tax shelter, pretty much a non-country and somewhere with mountains. If Spain or Italy needs assistance, then the contingent commitment of the remaining countries, especially France and Germany, would increase. A similar process operates in respect of the ECB. Germany is by far the largest creditor in TARGET2. The Netherlands, Finland and Luxembourg are the other creditors with all other Euro-Zone countries being net debtors within the system. The Bundesbank has current exposure of over Euro 750 billion to other central banks in the Euro-Zone. The TARGET2 net claims are not a true measure of the risk of the Bundesbank. The net balance would only be lost in the case of a breakup of the Euro-Zone and if sovereign central banks refuse to honour their debts. This risk is difficult to quantify. But there is a clear transfer of financing risk to the stronger core countries. This ultimately weakens their financial position materially. Germany provides an indication of the magnitude of the task. German guarantees supporting the EFSF are Euro 211 billion. The ESM will require a capital contribution from Germany. If the ESM lends its full commitment of Euro 500 billion and the recipients default, Germany’s liability could be as high as Euro 280 billion. There is also the indirect exposure via the ECB and the TARGET2 claims. The size of these exposures is large, both in relation to Germany’s GDP of around Euro 2.5 trillion and German private household assets which are estimated at Euro 4.7 trillion. Germany also has substantial levels of its own debt (around 81% of GDP). The increase in commitments or debt levels will absorb German savings, crippling the economy. Germany demographics, with an aging population, compound its problems. Over time, the transfer of risk will mean de facto debt mutualisation and financial transfers by stealth. This is precisely the outcome that Germany and its allies have sought to avoid. World of Pain… De facto integration may help make European debt problems more manageable. As a single unit, the Euro-Zone’s current account is nearly balanced, its trade account has a small surplus, the overall fiscal deficit is modest and the aggregate level of public debt while high is more manageable. Around 75% of its trade is within member nations, aided by removal of trade barriers and the common currency. Germany, the EU’s largest economy and one of the world’s largest exporters, sells over 60% of its products within the common market, much of it to other Euro-Zone members. But significant disparities between individual Euro-Zone members of income levels, public finances, external balances and debt levels will necessitate a net wealth transfer from richer nations to weaker members. Stronger more creditworthy members will also have to underwrite the borrowings of weaker nations. Despite opposition to such joint and several liabilities from net lenders such as Germany, Finland and Netherlands, this process is now the most likely outcome. Stealth integration will have substantial costs. For the peripheral nations, financing assistance will be available, albeit in doses which will keep the recipient barely alive and prolong its suffering. It will require adherence to strict austerity policies, which may mire the economies in recession. Living standards will be reduced by internal devaluation. In the period since the introduction of the Euro, German unit-labour costs rose by 7-8%, compared to 30% in Italy, 35% in Spain and 42% in Greece. These rises have to be reversed to increase competitiveness. Employment conditions, pension benefits and social benefits provided by the state will become less generous. Taxes will rise, reducing after tax income. In the stronger nations, savers will see the value of their savings fall. They too will suffer losses of social amenities as income and savings are directed to support weaker Euro-Zone members. As integration becomes a reality, ordinary Germans will discover the reality of an old proverb: “if you stay the beast will eat you, if you run the beast will catch you”. Europe will find itself locked in a period of subdued economic activity and high unemployment. The core Euro-Zone countries, especially Germany and France, are increasingly affected by the problems of the rest of Europe. In early 2013, Joerg Asmussen, a German ECB board member, was quoted as predicting Germany could become the “Sick Man of Europe” if the problems continued. The dry economic language masks a world of human pain as life will turn into a grim struggle for survival. Unemployment rates, which in some countries approach 30% and 50% for people under 25 years, will feed increasing instability. Social unrest and conflict is likely. Militant opposition to austerity and declines in living standards will increase. Major political parties in many countries now poll less than 50% of the total vote, requiring unstable coalitions which make decision making difficult. As Jean-Claude Juncker, the Luxembourg Prime Minister noted: “We all know what to do, we just don’t know how to get re-elected after we have done it.” The political environment favours political parties which favour more radical actions, such as abandonment of the Euro or default on outstanding debts. Opposition to immigration and cultural minorities, often taking the form of violent action, is growing. It is these realities rather than the economics that may determine the future of Europe. European political leaders are increasingly optimistic in their language- the Euro-Zone crisis is “behind us”; the problems are “resolved”. Only German Chancellor Angela Merkel has sounded cautious, arguing that the crisis is likely to continue for many years. It may be tactic acknowledgement of the cost of the crisis to Germany. It may also a strategy to prepare Germans for the harsh reality of the likely endgame. While de facto integration is the likely outcome, a smooth transition is not guaranteed. Outflows of actual cash to beleaguered nations, the first claims on the German budget, significant rating downgrades for core Euro-Zone members or a rise in inflation and consumer prices may alter the dynamic quickly. If voters in Germany and other stronger states become aware of the reality of debt pooling and institutionalised structural wealth transfers, then the outcome might be different. Continued deterioration in economic activity requiring further bailouts as well as unsustainable unemployment and social breakdown may still trigger repudiation of debts, defaults or a breakdown of the Euro and the Euro-Zone.
In 1979, the publication of Harvard sociologist Ezra Vogel’s international best-selling book Japan as Number 1signalled the nation’s arrival as an economic power. Today, Japan’s industrial and economic decline is palpable. But in 2012, Japan’s Nikkei 225 stock average rose by around 23%. Much of the increase reflects faith in the reflation strategy of second time Prime Minster Shinzo Abe to increase growth through an additional US$120 billion of public spending, create inflation to reduce the debt to GDP ratio and devalue the Yen. The strategies, which have all been tried before with limited success, may not restore the health of the Japanese economy. Dark Statistics… In the post war period, Japan enjoyed decades of strong economic growth – around 9.5% per annum between 1955 and 1970 and around 3.8% per annum between1971 and 1990. Since the collapse of the Japanese debt bubble in 1989/ 1990, Japanese growth has been sluggish, averaging around 0.8% per annum. Nominal gross domestic product (“GDP”) has been largely stagnant since 1992. Japan’s economy operates far below capacity, with the output gap (the difference between actual and potential GDP) being around 5- 7%. The Japanese stock market is around 70-80% below its highs at the end of 1989. The Nikkei Index fell from its peak of 38,957.44 at the end of 1989 to a low of 7,607.88 in 2003. It now trades around 8,000-12,000. Japanese real estate prices are at the same levels as 1981. Short term interest rates are around zero, under the Bank of Japan’s (“BoJ”) Zero Interest Rate (“ZIRP”) policy which has been in place for over a decade. 10 year Japanese government bonds yield around 1.00% per annum. Since 1990, public finances have deteriorated significantly. Government spending to stimulate economic activity has outstripped tax revenues, resulting in a sharp increase in Japanese government gross debt to around 240% of GDP. Net debt (which excludes debt held by the government itself for monetary, pension and other reasons) is about 135%. The US government has gross and net debt of 107% and 84%. Total gross debt (government, non-financial corporation and consumer) is over 450% of GDP, compared to around 280% for the US. Japan’s demographics parallel its economic decline. Japan’s population is forecast to decline from its current level of 128 million to around 90 million by 2050 and 47 million by 2100. A frequently repeated joke states that in 600 hundred years based on the present rate of decline there will be 480 Japanese left. The proportion of Japan’s population above 65 years will rise from 12% of the total population to around 23%. Japan’s work force is expected to fall from 70% currently by around 15% over the next 20 years. For every two retirees there will be around three working people, down from six in 1990. According to one forecast by 2050, Japan will have a median age of 52, the oldest society ever known. Currently sales of adult diapers now exceed those intended for babies. Japan’s problems have been compounded by two major natural disasters – the 1994 Kobe earthquake and the 2011 Tohoku earthquake and tsunami. In the face of the nation’s long term decline, Japanese politics has become increasingly fractious. Frequent changes of leadership, often driven by arcane internal factional politics, have created an unstable environment and a lack of policy continuity. Japan has had seven prime ministers in six years and six finance ministers in three years. Former Brazilian President Luiz Inácio Lula da Silva once joked that in Japan you say good morning to one prime minister and good afternoon to another. Origins of the Crisis… Japan’s post war economic success, like that in Germany, was based on an export driven economic model, using low costs and manufacturing competence. An under-valued Yen provided Japanese exporters with a competitive advantage. The Plaza Accord signed on 22 September 1985 called for France, West Germany, Japan, the United States, and the United Kingdom to devalue the dollar in relation to the Japanese Yen and German Deutsche Mark by intervening in currency markets. Between 1985 and 1987, the Yen increased in value by 51% against the dollar. Japan moved from an era of En’yasu, an inexpensive Yen, to a period of Endaka or Endaka Fukyo, an expensive Yen. The higher Yen adversely affected Japanese exporters. Japanese economic growth fell sharply, from 4.4% in 1985 to 2.9% in 1986. Desperate to restore growth and offset the stronger Yen, the Japanese authorities eased monetary policy with the BoJ cutting interest rates from 5% to 2.5% between January 1986 and February 1987. The lower rates led to a rapid increase in debt funded investment, driving real estate and stock prices higher. At the peak of the “bubble” economy, the 3.41 square kilometre (1.32 square miles) area of the Tokyo Imperial Palace had a theoretical value greater than all the real estate in the state of California. Seeking to reverse the unsustainable asset price inflation, the authorities increased interest rates to 6% between 1989 and 1990 triggering the collapse of the boom. As Japan’s economic problems worsened rapidly, the government responded with large fiscal stimulus programs. The BoJ cut interest rates to zero. But the policy measures failed to revive the economy, which slid into deflation. There was a parallel deterioration in public finances. At the time of collapse of the bubble economy, Japan’s budget was in surplus and government gross debt was around 20% of GDP. As the Japanese economy stagnated, weak tax revenues and higher government spending to resuscitate growth created substantial budget deficits. Japan’s total tax revenue is currently at a 24 year low. Corporate tax receipts have fallen to 50 year lows. Japan now spends more than 200 Yen for every 100 Yen of tax revenue received. The period of Japanese economic decline was known as the Lost Decade or Ushinawareta Jūnen. As the economy failed to recovery and the problems extended beyond 2000, it has come to be referred to as the Lost Two Decades or the Lost 20 Years (Ushinawareta Nijūnen). Japanese Airbags… Japan’s large pool of savings, low interest rates and a large current account surplus has allowed the build-up of government debt. Japan has a large pool of savings, estimated at around US$19 trillion, built up through legendary frugality and thrift during the nation’s rise to prosperity after World War II. High savings rates also reflected the country’s young age structure especially until the 1980s, the low level of public pension benefits, the growth of income levels through to the late 1980s, the bonus system of compensation, the lack of availability of consumer credit and incentives for saving. In recent years, household savings were complemented by strong corporate savings, around 8% of GDP. This reflects slow growth, excess capacity, lack of investment opportunities and caution driven by economic uncertainty. Much of these savings are invested domestically. A significant amount of the savings is held as bank deposits, including large amounts with the Japanese Postal System. In the absence of demand for credit from borrowers, the banks hold large quantities of government bonds to match the deposits, helping finance the government. Japanese banks hold around 65-75% of all Japanese government bonds (“JGBs”) with the Japanese Postal System being the largest holder. Around 90% of all JGBs are held domestically. The high levels of debt are sustainable because of low interest rates, driven by the BoJ’s ZIRP and successive rounds of JGB bond purchases as part of quantitative easing (“QE”) programs since 2001. The BoJ balance sheet is now around US$2 trillion an increase from around 10% of Japan’s GDP to 30% since the mid-1990s. BoJ holdings of JGBs are around US$1.2 trillion, around 11% of the total outstanding. Low interest rates perversely have not discouraged investment in bank deposits or government bonds. This reflects the poor performance of other investments, such as equity and property, during this period. The strong Yen has increased the risk of foreign investments. Although nominal returns are low, Japanese investors have received high real rates of return, because of falling prices or deflation. Over the last 50 years, Japan has also run large current account surpluses, other than in 1973–1975 and 1979–1980 when high oil prices led to large falls in the trade balances. The current account surplus has resulted in Japan accumulating foreign assets of around US$4 trillion or a net foreign investment position of approximately 50 % of GDP. This helped Japan avoid the need to finance its budget deficit overseas and also boosted domestic resources, increasing demand for JGBs. Since the global financial crisis and more recent European debt crisis, Japan has been viewed as a “safe haven”. Investors have purchased Yen and JGBs, pushing rates to their lowest levels in almost a decade and increasing foreign ownership of JGBs to around 9%, the highest level since 1979, the first year for which comparable data is available. These factors have assisted Japan to finance its budget deficit. Airbags designed to protect occupants of a car from injury in a crash only work once. Similarly, the factors which allowed Japan to increase its government debt levels are unlikely to continue. Change in the Weather… Following the collapse of the bubble, policymakers implemented a variety of economic stimulus programs. Japan’s budget surplus of 2.4% in 1991 has become a chronic budget deficit, increasing from 2.5% in 1993 to about 8% by the end of the 1990s. It has remained high during the 2000s. The BoJ has tried unsuccessfully to increase inflation to reduce debt. Japanese inflation has averaged minus 0.2% in the 2000s, a decline from levels of 2.5% in the 1980s and 1.2% in the 1990s. The policies have failed to restore economic growth, trapping Japan in a period of economic stagnation. Nomura economist Richard Koo argues that Japan is experiencing a “balance sheet recession”, triggered by the collapse of financial asset prices. Financially insolvent firms are reducing debt – deleveraging- despite low interest rates. This is evidenced by a sharp fall in investment (currently around 22% of GDP, down from 32% in 1990) and corporations becoming net savers from net borrowers. Private consumption is weak, falling to about 57% of GDP, further reducing domestic demand. This reflects weak employment, lack of growth in income and the aging population. Strong exports and a current account surplus have partially offset the lack of domestic demand, as firms focused on overseas markets. With investment and consumption weak, large budget deficits have supported economic activity, avoiding an even larger downturn in economic activity. In a balance sheet recession, monetary policy is ineffective with limited demand for credit. GDP tends to decline by the amount of debt repayment and un-borrowed individual savings. Government stimulus spending is the primary driver of growth. Given the strategies have been tried unsuccessfully before, the Prime Minster Shinzo’s policies have a desperate quality. Although the measures will provide a short term lift in economic activity, it is unlikely to create a sustainable recovery. They will increase the budget deficit and government debt levels. Continued economic weakness, a decline in savings rates and a reversal of the current account surplus make the Japanese government debt burden increasingly unsustainable. Getting Poorer at Home… The Japanese government’s ability to finance spending is increasingly constrained by falling Japanese household savings rates, which have declined from between 15% and 25% in the 1980s and 1990s to under 3%, a level below the US until recently. This decline reflects decreasing income and the aging population. At around 5%, Japan’s unemployment rates are low relative to international peers but higher than the 2-3% levels that existed prior to 1991. The official rate understates real unemployment because of government employment adjustment subsidies and structural change in the Japanese labour to lower costs to offset the impact of a higher Yen and global competition. Wage have fallen with average annual salaries including bonuses falling every year since 1999 and decreasing by around 12% in total. Between 1994 and 2007, labour costs as a percentage of manufacturing output declined from73% to 49%. Japanese worker’s share of GDP fell to 65% in 2007, from a peak of 73% in 1999. In a change from the tradition of lifetime employment, 34% of the labour force (around) 20 million workers are employed in part-time or contract roles, an increase from 20% in 1990. These workers do not have job security, training or benefits associated with full time work. In 2009, previously unreleased government statistics revealed that 15.7% of Japanese, including 14% of children and 21% of the elderly, live below the poverty line.
The aging population further reduces the savings rate. Household surveys indicate that around a quarter of households with two people or more have no employment. In aggregate, the amount of money being paid to retirees from savings exceeds the amount of new money that is going into savings funds. This is compounded by low returns on investments which accelerates the rundown of savings. Getting Poorer Abroad… Japan’s current account surplus has also allowed the government to run large budget deficits which can be funded domestically. Since 2007, the Japanese trade account surplus has fallen sharply, turning into a deficit in 2012. The secular factors driving the fall include an appreciating Yen and slower global growth, which has reduced demand for Japanese products, such as cars and consumer electronics. In late 2012, territorial disputes with China exacerbated the decline in exports. It also reflects the impact of the Tohoku earthquake and tsunami as well as the subsequent decision to shut down Japanese nuclear power generators, which increased energy imports, especially Liquid Natural Gas. Deep seated structural factors also underlie changes in the trade account. Since the 1980s, rising costs and the higher Yen have driven Japanese firms to relocate some production facilities overseas, taking advantage of lower labour costs and circumventing trade barriers. More advanced, technologically complex and high value manufacturing was kept in Japan. But post 2007 Japanese firms have increasingly been forced to close these domestic production facilities as they have become uncompetitive. The combination of falling exports, lower saving rates, declining corporate earnings and cash surpluses is likely to move the Japanese current account into deficit. In turn, this will force Japan to become a net importer of capital to finance government spending, altering the dynamics of its finances. The Way It Ends… If Japan continues to run large budget deficits, as is likely, then the falling saving rate and reversal in its current account will make it more difficult for the government to borrow, at least at current low rates. Ignoring foreign borrowing and debt monetisation by the central bank, the stock of private sector savings limits the amount of government debt. In the case of Japan, this equates to around 250-300% of GDP. Japan’s gross government debt will reach this level around 2015, although net government debt will not reach this limit until after 2020. Even before Japan’s government debt exceed household’s financial assets, the declining savings rate and increasing drawing on savings by aging households will reduce inflows into JGBs making domestic funding of the deficit more difficult. Insurance companies and pension funds are increasingly selling their holdings or reducing purchases to fund the increase in payouts to people eligible for retirement benefits. Institutional investors and to a lesser extent retail investors are also increasingly investing in other assets, including foreign securities, in an effort to increase returns and diversify their portfolios. Forecast current account deficits will complicate the government’s financing task. Japan’s large merchandise trade surplus has shrunk and will remain under pressure reflecting weak export demand and high imported energy costs. Japan’s large portfolio of foreign assets will cushion the effects for a time. Japan has accumulated large foreign assets totalling around US$4 trillion, making it the world’s biggest net international creditor. The BoJ is the largest investor in US Treasury bonds, with holdings of around US$1 trillion. But even if net income from foreign assets (interest payments, profits and dividends) stays constant, Japan’s overall current account may move into deficit as soon as 2015. As the drawdown on financial assets to finance retirement accelerates, Japan will initially run down its overseas investments, losing its net foreign asset position. Unless public finances improve, Japan ultimately will be forced to finance its budget deficit by borrowing overseas. Where the marginal buyers of JGBs are foreign investors rather than domestic Japanese investors, interest rates may increase, perhaps significantly. Even at current low interest rates, Japan spends around 25-30% of its tax revenues on interest payments. At borrowing costs of 2.50% to 3.50% per annum, two to three times current rates, Japan’s interest payments will be an unsustainable proportion of tax receipts. Higher interest rates will also trigger problems for Japanese banks, Japanese pension funds and insurance companies, which also have large holdings of JGBs. JGBs total around 24% of all bank assets, which is expected to rise to 30% by 2017. An increase in JGB yields would result in immediate mark-to-market large losses on existing holdings, although higher returns would boost income longer term. BoJ estimates that a 1% rise in rates would cause losses of US$43 billion for major banks, equivalent to 10% of Tier 1 Capital for major banks or 20% for regional banks. To avoid the identified chain of events, Japan must address the core problems. But reductions in the budget deficit are difficult. Spending on social security accounts and interest expense now totals a major part of government spending. Increasing health and aged care costs are expected by 2025 to be around 10-12% of GDP. An aging population and shrinking workforce will continue to drive slower growth and lower tax revenues. Tax increases are politically unpopular. Reductions in the budget deficit are likely to reduce already weak economic activity, compounding the problems. Japanese policy makers have other options. Financial repression forcing investment in low interest JGBs is one alternative. The BoJ can maintain its zero rate policy and monetise debt to finance the government. Japan can try to inflate away their debt. But ultimately, Japan may have no option other than a domestic default to reduce its debt levels. Older Japanese, especially retirees who are major holders of JGBs, would suffer large losses. Younger Japanese would benefit from the reduction in debt and reduced claims on future tax revenues. Such a drastic alternative, with its massive economic and social costs, is difficult to conceive other than as the last option. Cassandra in Japan… Investors and traders have repeatedly bet on a Japanese crisis, usually by short selling JGBs to benefit from higher rates. With low Japanese interest rates, the risk of the trade has always seemed limited while the potential profit large. But the bet has failed each time, giving the strategy its name – the widow maker. Given its large domestic savings and also the ability of the BoJ to further monetise its debt, the status quo can be maintained for a little longer. But eventually Japan’s deteriorating public finances and declining ability to finance itself domestically will coincide with weakening ratings and large refinancing needs. Japan’s deteriorating public finances and declining ability to finance itself domestically will coincide with weakening ratings and large refinancing needs. Although no longer AAA since May 2009, Japan currently has a strong debt rating – AA3 (Moody’s Investor Services) from or AA minus (Standard & Poor’s). In 2012, Fitch downgraded the country’s credit rating to A plus from AA. Its rapidly deteriorating financial position will place continuing pressure on its rating, making fund raising more difficult and expensive especially outside Japan. Japan has an average debt maturity of 6 years, shorter than Spain, Italy and France. Around 60% of its debt must be refinanced in the next 5 years. This will expose Japan to the discipline of market investors at a vulnerable moment. Once the problems emerge, they will be difficult to contain. As Economist Rudiger Dornbush once observed: “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought”. This piece is cross-posted from Naked Capitalism with permission.
Below are excerpts from the testimony of
Marriner Eccles to the Senate Committee on the Investigation of Economic
Problems in 1933. It is an historic document – laying out the future terms of
the Federal Deposit Insurance Corporation, the management of money supply
nationally through open market operations, the Bretton Woods Accord on currency
stability, mortgage refinancing as monetary stimulus, and reforms of the Federal
Reserve System to eradicate the excesses of untamed capitalism and financial
dominance of Wall Street. He proposes higher income and inheritance taxes as
essential to promote economic growth, curb inequality and forestall political
instability. He encourages federal regulation of child labor, unemployment
insurance, social security and other farsighted reforms. And he avows himself a
capitalist throughout.
Although he was a titan of industry - with banks,
railroads and corporations spanning the American west - Eccles was born the son
of an illiterate, bigamist, Mormon, Scottish immigrant. He was about as far as
you could get from the Eastern elite ranks that ran US banking on Wall Street.
But he sure understood money, economics and trade, and had the personal drive
and charisma to carry his point with the president and with
Congress.
Following his testimony, the Utah banker was invited by
Franklin Roosevelt to come to Washington to spearhead legislation to enact his
proposed reforms. Within two years he had drafted and enacted the Securities Act
of 1933 and the Banking Act of 1933(a.k.a., The Glass-Steagall Act, which
separated investment and commercial banking and established the FDIC) and the
Banking Act of 1935 (which created the modern Board of Governors of the Federal
Reserve System and Federal Open Market Committee). He served as Chairman of the
Board of Governors of the Federal Reserve System from 1934 until
1951.
Read this and know that just one person, with vision and
principles, can make a difference to the world in a time of crisis, establishing
the basis for decades of prosperity and growth.
[page 8]
Before effective action can be taken to stop the
devastating effects of the depression, it must be recognised that the breakdown
of our present economic system is due to the failure of our political and
financial leadership to intelligently deal with the money problem. In the real
world there is no cause nor reason for the unemployment with its resultant
dsestitution and suffering of fully one-third of our entire population. We have
all and more of the material wealth which we had at the peak of our prosperity
in the year 1929. Our people need and want everything which our abundant
facilities and resources are able to provide for them. The problem of production
has been solved, and we need no further capital accumulation for the present,
which could only be utilised in further increasing our productive facilities or
extending further foreign credits. We have a complete economic plant able to
supply a superabundance of not only all the necessities of our people, but the
comforts and luxuries as well. Our problem, then, becomes one purely of
distribution. This can only be brought about by providing purchasing power
sufficiently adequate to enable the people to obtain the consumption goods which
we, as a nation, are able to produce. The economic system can serve no other
purpose and expect to survive.
If our problem is then the result of the
failure of our money system to properly function, which today is generally
recognised, we then must turn to the consideration of the necessary corrective
measures to be brought about in that field; otherwise, we can only expect to
sink deeper in our dilemma and distress, with possible revolution, with social
disintegration, with the world in ruins, the network of its financial
obligations in shreds, with the very basis of law and order shattered. Under
such a condition nothing but a primitive society is possible. Difficult and slow
would then be the process of rebuilding and it could only then be brought about
on a basis of a new political, economic and social system. Why risk such a
catastrophe when it can be averted by aggressive measures in the right direction
on the part of the Government?
* * *
[page 9]
We could do
business on the basis of any dollar value as long as we have a reasonable
balance between the value of all goods and services if it were not for the debt
structure. The debt structure has obtained its present astronomical proportions
due to an unbalanced distribution of wealth production as measured in buying
power during our years of prosperity. Too much of the product of labor was
diverted into capital goods, and as a result what seemed to be our prosperity
was maintained on a basis of abnormal credit both at home and abroad. The time
came when we seemed to reach a point of saturation in the credit structure
where, generally speaking, additional credi was no longer available, with the
result that debtors were forced to curtail their consumption in an effort to
create a margin to apply on the reduction of debts. This naturally reduced the
demand for goods of all kinds, bringing about what appeared to be
overproduction, but what in reality was underconsumption measured in terms of
the real world and not the money world. This naturally brought about a falling
in prices and unemployment. Unemployment further decreased the consumption of
goods, which further increased unemployment, thus bringing about a continuing
decline in prices. Earnings began to disappear, requiring economies of all kinds
– decreases in wages, salaries, and time of those employed.
[page
10]
The debt structure, in spite of the great amount of liquidation
during the past three years, is rapidly becoming unsupportable, with the result
that foreclosures, receiverships and bankruptcies are increasing in every field;
delinquent taxes are mounting and forcing the closing of schools, thus breaking
down our educational system, and moratoriums of all kinds are being resorted to
– all this resulting in a steady and gradual breaking down of our entire credit
structure, which can only bring additional distress, fear, rebellion, and
chaos.
* * *
As an example of Government control and operation of
the economic system look to the period of the war, at which time, under
Government direction, we were able to produce enough and support not only our
entire civilian population on a standard of living far higher than at present,
but an immense army of our most productive workers engaged in the business of
war, parasites on the economic system, consuming and destroying vast quantities
produced by our civilian population; we also provided allies with an endless
stream of war materials and consumption goods of all kinds. It seemed as though
we were enriched by the waste and destruction of war. Certainly we were not
impoverished, because we did not consume and waste except that which we
produced. As a matter of fact we consumed and wasted less than we produced as
evidenced by the additions to our plant and facilities during the war and the
goods which we furnished to our allies. The debt incurred by the Government
during the war represents the profit which accrued to certain portions of our
population through the operation of our economic system. No Government debt
would have been necessary and no great price inflation would have resulted if we
had drawn back into the Federal Treasury through taxation all of the profits and
savings accumulated during the war.
* * *
[page 11]
How
was it that during the period of the prosperity after the war we were able in
spite of what is termed our extravagance – which was not extravagance at all; we
saved too much and consumed too little – how was it we were able to balance a
$4,000,000,000 annual Budget, to pay off ten billion of the Government debt, to
make four major reductions in our income tax rates (otherwise all of the
Government debt would have been paid), to extend $10,000,000,000 credit to
foreign countries represented by our surplus production which we shipped abroad,
and add approximately $100,000,000,000 by capital accumulation to our national
wealth, represented by plants, equipment, buildings, and construction of all
kinds? In the light of this record, is it consistent for our political and
financial leadership to demand at this time a balanced Budget by the
inauguration of a general sales tax, further reducing the buying power of our
people? Is it necessary to conserve Government credit to the point of providing
a starvation existence for millions of our people in a land of superabundance?
Is the universal demand for Government economy consistent at this time? Is the
present lack of confidence due to an unbalanced Budget?
What the public
and the business men of this country are interested in is a revival of
employment and purchasing power. This would automatically restore confidence and
increase profits to a point where the Budget would automatically be balanced in
just the same manner as the individual, corporation, State, and city budget
would be balanced.
[page 12]
During the past three years there
has been such tremendous liquidation and scaling down of debts that
extraordinary measures have had to be taken to prevent a general collapse of the
credit structure. If such a policy is continued what assurance is there that the
influences radiating from a marking down of the claims of creditors will not
result in a further decline of prices? In other words, after we have reduced all
debts through a basis of scaling down 25 per cent to 50 per cent, what reason
have we to expect that prices will not have a further decline by like amount?
And then again, the practical difficulties of bringing about such a adjustment
on a broad scale seem to be insurmountable.
The time element required
would indefinitely prolong the depression; such a policy would necessitate the
further liquidation of banks, insurance companies, and all credit institutions,
for if the obligations of public bodies, corporations, and individuals were
appreciably reduced the assets of such institutions would diminish
correspondingly, forcing their liquidation on a large scale. Nothing would so
hinder any possibility of recovery. Bank and insurance failures destroy
confidence and spread disaster and fear throughout the economic world. The
present volume of money would diminish with increased hoarding and decreased
credit and velocity, making for further deflation and requiring increased
Government support without beneficial results until we would be forced from the
gold standard in spite of our 40 per cent of the world’s gold, and, at that
point, an undesirable and possibly an uncontrolled inflation with all its
attendant evils would likely result, and thus the very action designed to
preserve the gold standard and re-establish confidence would destroy
both.
[page 13]
We have nearly one and a half billion currency
more in circulation at the present time than we had at the peak of 1929, and
under our present money system we are able to increase this by several billion
more without resorting to any of the three inflationary measures popularly
advocated. There is sufficient money available in our present system to
adequately adjust our present price structure. Our price structure depends more
upon the velocity of money than it does upon its volume.
* * *
In
1929 the high level of prices was supported by a corresponding velocity of
credit. The last Federal Reserve Bulletin gives an illuminating picture of this
relationship as shown by figures of all member banks. From 1923 to 1925 the
turnover of deposits fluctuated from 26 to 32 times per year. From the autumn of
1925 to 1929 the turnover rose to 45 times per year. In 1930, with deposits
still increasing, the turnover declined at the year end to 26 times. During the
last quarter of 1932 the turnover dropped to 16 times per year. Note that from
the high price level of 1929 to the low level of the present this turnover has
declined from 45 to 16, or 64 per cent.
[page 14]
I repeat there
is plenty of money today to bring about a restoration of prices, but the chief
trouble is that it is in the wrong place; it is concentrated in the larger
financial centers of the country, the creditor sections, leaving a great portion
of the back country, or the debtor sections, drained dry and making it appear
that there is a great shortage of money and that it is, therefore, necessary for
the Government to print more. This maldistribution of our money supply is the
result of the relationship between debtor and creditor sections – just the same
as the realtion between this as a creditor nation and another nation as a debtor
nation – and the development of our industries into vast systems concentrated in
the larger centers. During the period of the depression the creditor sections
have acted on our system like a great suction pump, drawing a large portion of
the available income and deposits in payment of interest, debts, insurance and
dividends as well as in the transfer of balances by the larger corporations
normally carried throughout the country.
[page 15]
The
maladjustment referred to must be corrected before there can be the necessary
velocity of money. I see no way of correcting this situation except through
Government action.
[page 21]
Mr Eccles: Of course, the way I look
at this matter is that we have the power to produce, just as in the period of
prosperity after the war demonstrated when we had a standard of living for a
period from 1921 to 1929 which, of course, was far in excess of what it is now.
Yet in spite of that standard of living we saved too much a I have previously
tried to show.
Senator Gore: You have got Foster in the back of your
head?
Mr Eccles: I only wish there were more who had. We saved too much
in this regard, that we added too much to our capital equipment. Creating
overproduction in one case and underconsumption in the other because of an
uneconomic distribution of wealth production. . . . Of course, we are losing
$2,000,000,000 per month in unemployment. I can conceive of no greater waste
than the waste of reducing our national income about half of what it was. I can
not conceive of any waste as great as that. Labor, after all, is our only source
of wealth.
[page 22]
There could be no waste in post offices or
in roads or in schools. You would have something to show for it. With war all
you have left is the expense of taking care of maimed and crippled and sick
veterans. That is what is left from war. And it is all wastage.
Senator
Gore: You have touched the point. The real cause of the existing trouble was the
war, with destruction of over 300 billion dollars of wealth in four years. We
are paying the price now. The boys paid the price in blood on the field. We are
paying the economic price today. And you may just as well pass a resolution to
raise the dead that fell in France as to try to pass laws to avert the
inevitable consequences of that war.
Mr Eccles: It is true we are
suffering the consequences of the war, but there is no reason why we should be
suffering from the consequences of the war if it had not been for the
international or the interallied debt that resulted from it. WE are suffering
from a debt structure. We are not suffering from the waste, because after all,
we know today that we have the power and the facilities to produce certainly all
that the people of this country need and want.
* * *
We now see,
after nearly four years of depression, that private capital will not go into
public works or self-liquidating projects except through government and that if
we leave our “rugged individual” to follow his own interest under these
conditions he does precisely the wrong thing. Each corporation for its own
protection discharges men, reduces pay rolls, curtails its orders for raw
materials, postpones construction of new plants and pays off bank loans, adding
to the surplus of unusable funds. Every single thing it does to reduce the flow
of money makes the situation worse for business as a whole.
[page
24]
I am talking about private credit. If it is credit we need why do not
say 200 of our great corporations controlling 40 per cent of our industrial
output that are in such shape that they do not need credit – they have great
amounts of surplus funds – if it is credit that is needed why do they not put
men to work? For the very reason that there is not a demand for goods, that we
have destroyed the ability to buy at the source through the operation of our
capitalistic system, which has brought about such a maldistribution of wealth
production that it has gravitated and gravitated into the hands of – well,
comparatively few. Maybe several millions of people. We have still got the
unemployment and have got no buying power as a result.
[page 25 –
proposal of bank deposit insurance and failed bank resolution]
[page 27 –
laying out the basis for what was later to be the FDIC]
However, there is
always this danger about that class of thing [Government guarantee of bank
deposits]. It encourages bad practices and bad management. It may put a premium
on them, which of course we do not want to do, and if it is done there must be
rules and regulations for the proper conduct of banks requiring eligibility, and
if they fail to meet the eligibility they would be suspended after so much
notice, and the fund would be drawn upon to take care of any loss.
[page
31]
Farm mortgages at present are possibly the most undesirable and
frozen of all loans, and frozen loans are preventing, to some extent, the
necessary expansion of credit. The plan I have proposed [to refinance existing
farm mortgages at new lower rates] will very effectively and immediately make
liquid billions of dollars of assets for which there is no market today, while
at the same time it will bring about a reduction of at least one-third of the
average annual payments on the farm debt now required to be made by farm
mortgage debtors without requiring any financing or loss by the Federal
Government, thus bringing about the necessary relief in the farm mortgage field.
This plan has the advantage, as a result of the Government guarantee of the
Federal land bank bonds, of diverting surplus funds carried in the great
creditor sections into the indirect financing of farm mortgages where it is
impossible even at a high rate of interest, which farmers can not pay, to
attract those funds directly.
* * *
No program designed to bring
this country out of the depression can be considered apart from the relations of
this country to the rest of the world unless a policy of complete isolation is
adopted and an embargo put on gold exports and our domestic economy adjusted to
meet such a condition.
Our international problems are far more difficult
and will be slower to work out because of our inability to control the action of
other nations. These problems can be met only through international conferences
over a period of time. The most important of these problems and the one which
must be settled before any progress can be made in the meeting of our domestic
or other foreign problems is the problem of interallied debts.
There is a
great demand on the part of the public and most of the press of this country
that these debts be paid. It seems to me that our political leaders have lacked
the courage to face this problem in a realistic manner. This has greatly
contributed to prolonging the depression. The public, generally speaking, is not
fully informed as to the impossibility of our foreign debtors complying with
these demands, which cn only be complied with at the expense of our own people.
[page 32]
It is elementary that debts between nations can
ultimately be paid only in goods, gold, or services, or a combination of the
three. We already have over 40 per cent of the gold supply of the world – that
is not true; it is between 35 and 40 per cent – and as a result most of the
former gold standard countries have been forced to leave that standard and
currency inflation has been the result. This has greatly reduced the cost of
producing foreign goods in terms of our dollar and has made it almost impossible
for foreign countries to buy American goods because of the high price of our
dollar measured in the depreciated value of their money. This naturally has
resulted in debtors trying to meet their obligations by producing and selling
more than they buy, thus enabling them to have a favourable balance of trade
necessary to meet their obligations to us. If this country is to receive payment
of foreign debts, it must buy and consume more than it produces, thus creating a
trade balance favourable to our debtors.
* * *
We must choose
either between accepting sufficient foreign goods to pay the foreign debts owing
to this country, or cancel the debts. This is not a moral problem, but a
mathematical one.
[page 33 – the outline of what later became the
Bretton Woods Accord]
Cancellation, or a settlement of the debts on a
basis which would practically amount to cancellation, in exchange for
stabilisation of the currency of the debtors, together with certain trade
concessions and an agreement to reduce armaments would be a small price for this
country to pay as compared with the great benefits which the entire world,
including ourselves, would derive therefrom. Without a stabilisation of foreign
currencies it will be difficult, if not impossible, in my opinion, to
substantially raise the price level in this country as long as we stay on a gold
basis. Our debtors will default and we will likely be forced to abandon gold and
depreciate our currency in relation to that of other countries in order to raise
our price level in this country and to meet foreign competition unless we are
instrumental in inducing foreign countries to stabilise their currencies on a
gold basis, or gold and silver basis if action is taken internationally to
remonetise silver.
[page 33]
Senator Shortridge: Then I take it
you would have the tariffs reduced?
Mr Eccles: No. Debts cancelled. Then
I think with the prosperity that you would get in this country you can collect
more than that in income and inheritance taxes when you stop this loss of
$2,000,000,000 a month through unemployment. You start the process of wealth,
and even a capitalist is far better off. I am a capitalist.
* *
*
The program which I have proposed is largely of an emergency nature
designed to bring rapid economic recovery. However, when recovery is restored, I
believe that in order to avoid future disastrous depressions and sustain a
balanced prosperity, it will be necessary during the next few years for the
Government to assume a greater control and regulation of our entire economic
system. There must be a more equitable distribution of wealth production in
order to keep purchasing power in a more even balance with production.
If this is to be accomplished there should be a unification of our
banking system under the supervision of the Federal Reserve Bank in order to
more effectively control our entire money and credit system; a high income and
inheritance tax is essential in order to control capital accumulations (this
diversion of taxes should be left solely to the central government – the real
property and sales tax left to the States); there should be national child
labor, minimum wage, unemployment insurance and old age pension laws (such laws
left up to the States only create confusion and can not meet the situation
nationally unless similar and uniform laws are passed by all States at the same
time, which is improbable); all new capital issues offered to the public and all
foreign financing should receive the approval of an agency of the Federal
Government; this control should also extend to all means of transportation and
communication so as to ensure their operation in the public interest. A national
planning board, similar to the industries board during the war, is necessary to
the proper coordination of public and private activities of the economic
world.
Such measures as I have proposed may frighten those of our people
who possess wealth. However, they should feel reassured in reflecting upon the
following quotation from one of our leading economists:
It is utterly impossible, as this country has demonstrated again
and again, for the rich to save as much as they have been trying to save, and
save anything that is worth saving. They can save idle factories and useless
railroad coaches; they can save empty office buildings and closed banks; they
can save paper evidences of foreign loans; but as a class they can not save
anything that is worth saving, above and beyond the amount that is made
profitable by the increase of consumer buying. It is for the interests of the
well to do – to protect them from the results of their own folly – that we
should take from them a sufficient amount of their surplus to enable consumers
to consume and business to operate at a profit. This is not “soaking the rich”;
it is saving the rich. Incidentally, it is the only way to assure them the
serenity and security which they do not have at the present
moment.
[page 35] I feel that one of two things is
inevitable: That either we have got to take a chance on meeting this
unemployment problem and this low-price problem or we are going to get a
collapse of our credit structure, which means a collapse of our capitalistic
system, and we will then start over. And I therefore would like to see us
attempt to regulate and operate our economy which today requires more action
from the top due to our entire interdependency than it did in our earlier days.
The quote I have bolded is my favorite part of this testimony,
though it is not Eccles' own words. I would be grateful for anyone who can track
down a proper citation for the quote. Eccles thought it was either Stuart Chase or William Trufant
Foster.
The world is focused on the fiscal cliff, a term referring to the scheduled reductions in the US budget deficit, by way of expiring tax cuts and mandatory spending cuts. The fiscal cliff may ironically improve public finances, reducing the deficit and slowing the increase in debt levels –America’s debt mountain. But going over the fiscal cliff will not of itself solve America’s fundamental financial problems.
Successive US administrations have avoided dealing with the US debt problem. Policy makers have adopted the rulebook of rapper Tupac Shakur: “Reality is wrong. Dreams are for real”. Debt Mountains…
US government debt currently totals around US$16 trillion. The US Treasury estimates that this debt will rise, in absence of corrective action, to around US$20 trillion by 2015, over 100% of America’s Gross Domestic Product (“GDP”).
There are also additional current and contingent commitments not explicitly included in the debt figures, such as US government support for Freddie Mac and Fannie Mae (known as government sponsored enterprises (GSEs)) of over US$5 trillion and unfunded obligations of over US$65 trillion for programs such as Medicare, Medicaid and Social Security. US State governments and municipalities have additional debt of around US$3 trillion.
US public finances deteriorated significantly over recent years. In 2001, the Congressional Budget Office (“CBO”) forecast average annual surpluses of approximately US$850 billion from 2009–2012 allowing Washington to pay off everything it owed.
The surpluses never emerged as the US government has run large budget deficits of around US$1 trillion per annum in recent years. The major drivers of this turnaround include: tax revenue declines due to recessions (28%); tax cuts (21%); increased defence spending (15%); non-defence spending (12%) higher interest costs (11%); and the 2009 stimulus package (6%).
Despite growing concern about the sustainability of its debt levels, demand for US Treasury securities from investors and other governments remains strong.
“Innovative” monetary policy from the US Federal Reserve has allowed the government to increase its debt levels. Around 60-70% of US government bonds have been purchased by the Federal Reserve, as part of successive rounds of quantitative Easing (“QE”).
Federal Reserve action has been a key factor in keeping rates low, allowing the US to keep its interest bill manageable despite increases in debt levels. The government’s average interest rate on new borrowing is around 1%, with one-month Treasury bills paying less than 0.10% per annum and 10 year bonds around 1.80% per annum.
But the current position is not sustainable. Cliff-Hanging…
In January 2013, in the absence of political agreement, a series of automatic tax increases and spending cuts will be triggered. These were part of the 2011 legislative package which increased the debt ceiling allowing the government to continue to borrow.
Several temporary tax cuts will expire. The total amount involved is around US$500 billion through to September next year.
These include President George Bush’s tax cuts on income, investments, married couples, families with children and inheritances, which were extended for 2 years by President Barack Obama. In addition, the Alternative Minimum Tax (“AMT”) would commence, affecting up to 26-30 million middle-class Americans, increasing their tax bill by an average of US$3,700. The payroll-tax cut of 2% and extended unemployment benefits for the long term unemployed (both implemented by the Obama Administration to stimulate the economy) would also expire. A number of other smaller tax cuts for individuals and business (most notable tax credits for research and development and a deduction for state sales taxes) would also terminate.
Automatic spending cuts will also commence, totalling about US$600 billion per year and US$6.1 trillion over 10 years. The spending cuts would cover most government programs including cuts in defence spending and domestic programs. Medicare, the federal health programme for the elderly, would reduce payments including a sharp reduction (as much as 30%) in reimbursements to doctors.
The automatic tax increases, non-renewal of tax cuts and spending cuts are equivalent to about 5% of GDP. In a recent Report, the non-partisan Congressional Budget Office (“CBO”) estimated that the tax increases and spending cuts would reduce output by approximately 3% and increase unemployment to 9.1% by the end of 2012. Corrective Services
Bringing US public finances under control requires bringing budget deficits down, through spending cuts, tax increases or a mixture. The fiscal cliff is merely a step down that long road.
The task is Herculean. Government revenues would need to increase by 20-30% or spending cut by a similar amount.
The US has a lower tax-to-GDP ratio (around 18%) than even much maligned Greece (around 20%). The tax-to-GDP in most developed countries is closer to 30%.
Given 45% of households do not pay tax (because they don’t earn enough or through credits and deductions) and 3% of taxpayers contribute around 52% of total tax revenues, a major overhaul of the taxation system would be necessary. Tax reform, especially higher or new taxes, is politically difficult.
Large components of spending – defence, homeland security, social security, Medicare, Medicaid, (growing) interest payments- are difficult to control and also politically sensitive, making it difficult to reduce.
Reducing the budget deficit and debt may also mire the US economy in a prolonged recession.
In 2009, students at National Defence University in Washington, DC, “war gamed” possible scenarios for bringing the US debt under control. Using a model of the economy, participants tried to get the federal debt down by increasing taxes and reducing spending.
The economy promptly fell into a deep recession, increasing the budget deficit and driving government debt to higher levels. This is precisely the experience of heavily indebted peripheral European nations, such as Greece, Ireland, Portugal, Spain and Italy.
As one participant in the National Defence University economic war game observed about the process of bringing US public finances under control: “You’ll never get re-elected and you may do more harm than good”. Political Debt Dancing…
A decision does not have to be reached by the end of 2012. The US Treasury can juggle its finances to purchase time till perhaps February 2013, especially if an agreement is likely. The major constraint is the need to increase the US Government’s borrowing cap or debt limit (currently US$16.4 trillion), which will be reached late in 2012 or early 2013.
Necessary reform of the tax system, especially a broadening of the tax base, and all spending, including social welfare programmes, is unlikely to be politically easy.
The re-elected President Obama’s ability to implement policy is constrained by continued Republican control of the House of Representatives. The Republicans remain reluctant to entertain tax increases or reductions in exemptions. The Democrats remain reluctant to consider reductions in entitlements and spending.
President Obama asserts that he has a mandate to reform the budget, especially increase taxes on wealthier Americans. Having lost the Presidential election and also having failed to make hoped for gains in Congressional elections, the Republicans are defensive. The GOP position is complicated by its fractious internal politics. More conservative elements believe that the loss was due to a shift to centrist policies and a return to more strict conservatism is required.
Republican House Speaker John Boehner has appeared conciliatory, signalling a willingness to consider some higher taxes. In the fissiparous world of US politics, nothing is guaranteed, especially given the short electoral cycle. The prospects of a definitive grand bargain remain poor. The more likely scenario is an incremental strategy.
A short term compromise will be needed, entailing extensions of some tax cuts and delaying some spending cuts. Negotiations on deeper structural tax and spending reforms may take longer. The latter would focus on some tax increases and some adjustment to spending.
President Obama may get some higher taxes. Republicans might accept higher income taxes, particularly for those earning more than $1 million per annum (rather than US$250,000 currently proposed). Some tax deductions and reporting loopholes may also be eliminated. In return, the administration may agree to changes in entitlement, such as higher Medicare retirement age and changes to indexation of social security benefits for inflation. There would probably also be cuts in spending on defence and other social welfare programs such as Medicaid.
The fiscal cliff or the measures likely to be adopted may not to be enough to address the deep-seated problems of American public finances.
What is needed is a radical overhaul of the tax system, including probably a value added tax and wind back of complex deductions and subsidies. What is also needed is a review of all spending, including defence and social welfare, to better target expenditure and align it with tax revenues.
But even with this action, without strong economic growth and decreases in unemployment, it is difficult to see a significant improvement in American public finances. The recent CBO report concluded that “[very few policies] are large enough, by themselves, to accomplish a sizeable portion of the deficit reduction necessary”. Our Debt, Your Problem…
Given the magnitude of the challenge and the lack of political will, the US will continue to spend more than it receives in taxes for the indefinite future, resulting in increases in US government debt. This will force the Federal Reserve to continue existing policies, especially debt monetisation by purchasing government bonds and the devaluation of the currency.
Debt monetisation (printing money in popular parlance) will continue, entailing the US Federal Reserve purchasing government bonds in return for supplying reserves to the banking system. Zero interest rates policy (“ZIRP”) in conjunction with debt monetisation will be used to devalue the US dollar.
Of the US gross government debt of US$16 trillion, the US government holds around 40% of the debt through the Federal Reserve, Social Security Trust Fund and other government trust funds. Individuals, corporations, banks, insurance companies, pension funds, mutual funds, state or local governments, hold 25%. Foreigner investors -China, Japan, oil exporting nations, Asian central banks and sovereign wealth funds- hold the remaining 35%.
Existing investors, like China, must now continue to purchase US dollars and government bonds to avoid a precipitous drop in the value of existing investments and to avoid a sharp rise in the value of their own currencies which would reduce export competitiveness.
Expedient in the short term, monetisation risks debasing the currency. Despite bouts of dollar buying on its safe haven status, the US dollar has significantly weakened. On a trade weighted basis, the US dollar has lost around 20% against major currencies since 2009. The US dollar has lost around 30% against the Swiss Franc, 25% against the Canadian dollar, 35% against the Australian dollar and 20% against the Singapore dollar over the same period.
The weaker US dollar also allows the US to enhance its competitive position for exports; in effect the devaluation is a de facto cut in costs. This is designed to drive economic growth.
As the US dollar weakens it improves America’s external position. US foreign investments and overseas income gain in value. But the major benefit is in relation to debt owned by foreigners.
As almost of its government debt is denominated in US dollars, devaluation reduces the value of its outstanding debt. It forces existing foreign investors to keep rolling over debt to avoid realising currency losses on their investments. It encourages existing investors to increase investment, to “double down” to lower their average cost of US dollars and US government debt. As John Connally, US Treasury Secretary under President Nixon belligerently observed: “Our dollar, but your problem.” Debt 22…
Given that the US constitutes around 25% of global economy, it is unlikely America’s problems will stay in America. The rest of the global economy is literally tied to the US as it edges closer to the cliff.
If the US takes the decisive action suggested then US growth will slow sharply in the short run, though the downturn may be shorter in duration and the longer term brighter. If, as likely, the US does not take decisive action then US growth will still be affected, though less significantly in the short run. But America’s debt position will become increasingly problematic. America’s long term growth prospects will also be adversely affected.
Any slowdown in US demand will affect its major trading partners such as China and Europe, exacerbating slowing growth affecting their trading partners.
US dollar devaluation will create pressure for appreciation of other currencies. This may force other nations to implement measures, such as zero interest rate policies, QE programs or capital controls, to halt or at least slow the appreciation of their currencies to avoid reductions in competitiveness.
Foreign investors in US dollars and government bonds are likely to suffer losses. Large investors like China and Japan may suffer significant declines in the value of these assets, reducing their national savings.
In Hamlet, William Shakespeare’s tragic hero states that: “I must be cruel only to be kind; thus bad begins, and worse remains behind”. In trying to preserve its position, the US now is increasingly adopting toxic economic and financial policies, which have the potential to damage other nations and ultimately its own future.
Former French Finance Minister Valery Giscard d’Estaing used the term “exorbitant privilege” to describe American advantages deriving from the role of the dollar as a reserve currency and its central role in global trade. That privilege now is “extortionate”.
Economist Herbert Stein observed: “If something cannot go on forever, it will stop”. How long the US can continue it profligate ways is unknown.
LONDON – It is generally agreed that the crisis of 2008-2009 was caused by excessive bank lending, and that the failure to recover adequately from it stems from banks’ refusal to lend, owing to their “broken” balance sheets.
Illustration by Paul Lachine
CommentsView/Create comment on this paragraphA typical story, much favored by followers of Friedrich von Hayek and the Austrian School of economics, goes like this: In the run up to the crisis, banks lent more money to borrowers than savers would have been prepared to lend otherwise, thanks to excessively cheap money provided by central banks, particularly the United States Federal Reserve. Commercial banks, flush with central banks’ money, advanced credit for many unsound investment projects, with the explosion of financial innovation (particularly of derivative instruments) fueling the lending frenzy.
CommentsView/Create comment on this paragraphThis inverted pyramid of debt collapsed when the Fed finally put a halt to the spending spree by hiking up interest rates. (The Fed raised its benchmark federal funds rate from 1% in 2004 to 5.25% in 2006 and held it there until August 2007). As a result, house prices collapsed, leaving a trail of zombie banks (whose liabilities far exceeded their assets) and ruined borrowers.
CommentsView/Create comment on this paragraphThe problem now appears to be one of re-starting bank lending. Impaired banks that do not want to lend must somehow be “made whole.” This has been the purpose of the vast bank bailouts in the US and Europe, followed by several rounds of “quantitative easing,” by which central banks print money and pump it into the banking system through a variety of unorthodox channels. (Hayekians object to this, arguing that, because the crisis was caused by excessive credit, it cannot be overcome with more.)
CommentsView/Create comment on this paragraphThis analysis, while seemingly plausible, depends on the belief that it is the supply of credit that is essential to economic health: too much money ruins it, while too little destroys it.
CommentsView/Create comment on this paragraphBut one can take another view, which is that demand for credit, rather than supply, is the crucial economic driver. After all, banks are bound to lend on adequate collateral; and, in the run-up to the crisis, rising house prices provided it. The supply of credit, in other words, resulted from the demand for credit.
CommentsView/Create comment on this paragraphThis puts the question of the origins of the crisis in a somewhat different light. It was not so much predatory lenders as it was imprudent, or deluded, borrowers, who bear the blame. So the question arises: Why did people want to borrow so much? Why did the ratio of household debt to income soar to unprecedented heights in the pre-recession days?
CommentsView/Create comment on this paragraphLet us agree that people are greedy, and that they always want more than they can afford. Why, then, did this “greed” manifest itself so manically?
CommentsView/Create comment on this paragraphTo answer that, we must look at what was happening to the distribution of income. The world was getting steadily richer, but the income distribution within countries was becoming steadily more unequal. Median incomes have been stagnant or even falling for the last 30 years, even as per capita GDP has grown. This means that the rich have been creaming off a giant share of productivity growth.
CommentsView/Create comment on this paragraphAnd what did the relatively poor do to “keep up with the Joneses” in this world of rising standards? They did what the poor have always done: got into debt. In an earlier era, they became indebted to the pawnbroker; now they are indebted to banks or credit-card companies. And, because their poverty was only relative and house prices were racing ahead, creditors were happy to let them sink deeper and deeper into debt.
CommentsView/Create comment on this paragraphOf course, some worried about the collapse of the household savings rate, but few were overly concerned. In one of his last articles, Milton Friedman wrote that savings nowadays took the form of houses.
CommentsView/Create comment on this paragraphTo me, this view of things explains much better than the orthodox account why, for all the money-pumping by central banks, commercial banks have not started lending again, and the economic recovery has petered out. Just as lenders did not force money on the public before the crisis, so now they cannot force heavily indebted households to borrow, or businesses to seek loans to expand production when markets are flat or shrinking.
CommentsView/Create comment on this paragraphIn short, recovery cannot be left to the Fed, the European Central Bank, or the Bank of England. It requires the active involvement of fiscal policymakers. Our current situation requires not a lender of last resort, but a spender of last resort, and that can only be governments.
CommentsView/Create comment on this paragraphIf governments, with their already-high level of indebtedness, believe that they cannot borrow any more from the public, they should borrow from their central banks and spend the extra money themselves on public works and infrastructure projects. This is the only way to get the big economies of the West moving again.
CommentsView/Create comment on this paragraphBut, beyond this, we cannot carry on with a system that allows so much of the national income and wealth to pile up in so few hands. Concerted redistribution of wealth and income has frequently been essential to the long-term survival of capitalism. We are about to learn that lesson again.
