Thursday, October 23, 2014

Repairing the Global Plumbing

NEWPORT BEACH – More than three years after the global financial crisis, the world still has a nasty plumbing problem. Credit pipes remain clogged, and only central banks are working to clear them. But their ability to do so is waning, posing yet another set of risks for Western economies blocked by too little growth, too much unemployment, deepening inequality, and debt in all the wrong places. Fortunately, it is not too late to build broader pipes that compliment and replace the damaged infrastructure.

The current situation embodies two narratives that seem contradictory, but are not. One speaks to the reality that most large companies with access to capital markets have no problem securing new funding. In fact, they have been remarkably successful in lengthening their debt maturities, accumulating cash, and lowering their future interest payments. In sum, they now have “fortress” balance sheets.

The other narrative speaks to an opposing, but equally valid reality. Too many small companies and households still find it difficult to borrow at reasonable terms. This includes those reliant on bank credit, as well as many mortgage holders with very high legacy interest rates and balances that exceed their homes’ market value.

From every angle, the extremity of this state of affairs – in which those with access to credit do not need it, and those who do cannot get it – is highly problematic. If left unattended, it leads to a gradual, and then accelerated, renewed deleveraging of the economic system, with the highest first-round costs – a longer unemployment and growth crisis – borne disproportionately by those least able to suffer them. In the next round, as the system slowly implodes, even those with healthy balance sheets would be impacted, accelerating their disengagement from a deleveraging world economy.

All of this slows social mobility, tears already-stretched safety nets, worsens inequality, and accentuates genuine concerns about the functioning and sustainability of today’s global economic system.

This is not just about socio-economic issues. There is also a political angle. With two competing, yet simultaneously valid narratives, ideological extremes harden. The result is even greater dysfunction in both process and content, ruling out any sustained policy attempt to make things better.

The problem has become acute in Europe, whose crisis has been belatedly recognized as reflecting something more than turmoil in the eurozone’s weakest countries. It also reflects broad-based contamination, resulting, most recently, in France’s loss of its vaunted AAA sovereign credit rating.

In the process, the efficacy of pan-European rescue mechanisms is being undermined. And, as fragilities increase – and as a financial wedge is driven into the eurozone’s core (Germany and France) – growth and employment prospects dim.

Central banks have recognized all of this for some time, prompting them to take enormous reputational and operational risks to slow the process. They have implemented a host of “unconventional policies” that previously would have been deemed unthinkable, even outrageous – and that can be seen in the enormous growth in their balance sheets.

In the last four years, the United States Federal Reserve’s balance sheet has more than tripled, from under $1 trillion to a mammoth $3 trillion. The growth relative to the size of the economy is even more stunning – from slightly more than 5% of GDP to 20%. The Bank of England’s balance sheet is also at 20% of GDP. And both seem to be itching to do even more.

The European Central Bank is often viewed as a laggard. No longer. Its balance sheet has now doubled, to a whopping 30% of GDP – and it, too, appears set to do even more. Mario Draghi, the ECB’s new president, recently said that he expects heavy take-up on the next three-year long-term refinancing operation, a powerful tool to pump cheap liquidity into the banks.

Unfortunately, the economic outcomes have come nowhere close to matching the intensity of these efforts. Effectively, the central banks have been unconventional bridges to nowhere, owing mainly to their imperfect tools and other government agencies’ inability or unwillingness to act. At some point – and we are nearing it – bridges to nowhere become a standalone risk: they can topple over.

Rather than just pumping liquidity into clogged pipes, countries can and should do more to build a more effective network of compensating conduits. In doing so, their main objective (indeed, the test for effectiveness) would be the extent to which new private-sector investment is “crowded in.”

It is high time to move on five fronts, simultaneously:

·         Countries such as Spain and the US need to be more forceful in unblocking the housing sector by making overdue decisions on burden sharing, refinancing, and conversion of idle and foreclosed housing stock.

·         Countries with excessive debt, such as Greece and Portugal, need to impose sizeable “haircuts” on creditorsin order to have a reasonable chance to restore medium-term debt sustainability and growth.

·         In several Western countries, public-private partnerships should be formed to finance urgently needed infrastructure investment.

·         Regulators should stop bickering about the future configuration of key financial institutions, and instead set a clearer multi-year vision that is also consistent across borders.

·         Finally, governments should inform their electorates explicitly and comprehensively that a few contracts written during the inadvisable “great age” of leverage, debt, and credit entitlements cannot be met, and must be rewritten in a transparent way that strikes a balance between generations, labor and capital, and recipients and taxpayers.

Such policies would allow healthy balance sheets around the world, both public and private, to engage in a pro-growth and pro-jobs process. They require leadership, focus, and education. Absent that, plumbing problems will become more acute, and the repairs more complex and threatening to virtually everyone – including both the “one percenters” and those who worrisomely are struggling at the margins of society.

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  1. CommentedSanjeev Chadha

    That what comes to mind in public private partnership is leasing away the vital public infrastructure into private hands,in cities and county sides all along the mainland.

  2. Commentedparthasarathy Shakkottai

    “No monetarily non-sovereign can survive long-term on internal taxes or borrowing.
    By contrast, Monetarily Sovereign nations do not need money coming in from outside their borders, because they create unlimited money simply by paying bills.
    For Greece and the other euro nations, long term survival requires one of two, and only two, events:
    1. Adopt some form of a sovereign currency, and become Monetarily Sovereign
    2. The EU give (not lend) euros to its member nations as needed.
    There are no other solutions. None.” from
    The euro is a flawed design. The countries in Europe have a common currency but have no political union (unlike the many states of USA with a common currency and a political union). The federal government funds the state governments to make up shortfalls and also redistributes taxes from wealthier states to the needy ones. All states of EU can’t be in surplus at the same time by mutual trade.
    Actual data on deficits is shown in
    Only deficits grow the economy! It is progressive to increase deficits. Government deficit is equal to private sector savings as in the equation
    (I – S) + (G – T) + (X – M) = 0
    (I – S) = private sector balance of investment and savings
    (G – T) = public sector balance govt spending and tax revenues
    (X – M) = foreign sector balance of export and import
    You can see this different version of the above chart in visual form in figure 4 by viewing the sectoral balances in the USA going back to 1952: If I-S is to be positive, G-T should be negative.
    Another reference to data on deficits is
    which shows 58 deficit years out of 70 years in the US economy.”
    The world in balance sheet recession: causes, cure, and politics : Richard C. Koo (Nomura Research Institute, Tokyo)
    Koo concludes “It is laudable for policy makers to shun fiscal profligacy and aim for self-reliance on the part of the private sector. But every several decades, the private sector loses its self-control in a bubble and sustains heavy financial injuries when the bubble bursts. That forces the private sector to pay down debt in spite of zero interest rates, triggering a deflationary spiral. At such times and at such times only, the government must borrow and spend the private sector’s excess savings, not only because monetary policy is impotent at such times but also because the government cannot tell the private sector not to repair its balance sheet….”
    Japan deficit spent for 16 years keeping nominal GDP constant till the economy paid down the private sector debt. This is an operational proof of MMT.
    For the Euro problem Koo suggests a form of quasi-monetary sovereignty:
    One way to solve this eurozone-specific problem of capital shifts would be to prohibit member nations from selling government bonds to investors from other countries. Allowing only the citizens of a nation to hold that government’s debt would, for example, prevent the investment of Spanish savings in German government debt. Most of the Spanish savings that have been used to buy other countries’ government debt would therefore return to Spain. This would push Spanish government bond yields down to the levels observed in the U.S. and the U.K., thereby helping the Spanish government implement the fiscal stimulus required during a balance sheet recession.
    The Maastricht Treaty with its rigid 3 percent GDP limit on budget deficits made no provision for balance sheet recessions. This is understandable given that the concept of balance sheet recessions did not exist when the Treaty was being negotiated in the 1990s. In contrast, the proposed new rule would allow individual governments to pursue autonomous fiscal policies within its constraint. In effect, governments could run larger deficits as long as they could persuade citizens to hold their debt. This would both instill discipline and provide flexibility to individual governments. By internalizing fiscal issues, the new rule would also free the European Central Bank from having to worry about fiscal issues in individual countries and allow it to focus its efforts on managing monetary policy.
    In order to maximize efficiency gains in the single market, the new restriction should apply only to holdings of government bonds. German banks should still be allowed to buy Greek private sector debt, and Spanish banks should still be allowed to buy Dutch shares.

  3. CommentedProcyon Mukherjee

    There is a case in point in the suggestion that those who have credit do not need it and those who need do not have it is already very clearly visible in the S&P 500 balance sheets that had amassed $1.3 Trillion in cash and cash equivalents. Such a huge rise in cash holdings is in one way a good indication of the S&P 500 performance but on the other it proves the very point that there is no need of credit for the real performers. Rather it holds testimony to the solemn challenge that America lacks the investment it needs in those forms of capital like the fixed capital, which would bridge investments to job growth that holds the key to the current conundrum.

    Procyon Mukherjee

  4. CommentedLuke Ho-Hyung Lee

    Excellent article with some valuable and timely policy suggestions, but unfortunately, I think they will still not be enough to change the situation.

    We have made a serious mistake in the real market (or supply chain) process of the market, that is, the blood stream of the market, over the last 20 to 30 years of the Modern Information Age. This mistake has created a maddening economic condition in real markets. If we do not fix it first, I believe that every new effort will be just as ineffective and useless as everything else we have tried.

    What mistake? Please see this article: “The Real Cause of the Current Economic Crisis and a Suggested Solution” .

    If we develop a new real market process by fixing that mistake, I believe much of the current major economic problems, such as too little growth, too much unemployment, deepening inequality, and debt in all the wrong places, could be solved easily and effectively.