The Question from Greece
The month of March, marked by Greece's massive debt restructuring which averted a vastly destabilizing credit default, appeared to some as if a major obstacle to economic recovery was finally removed. Yet, for others, it served to refresh a still puzzling question for the world's rich countries: can economic recovery ever take hold on shaky financial foundations?
By shaky financial foundations I refer to the insolvency risks still faced by a few big banks and sovereign governments, despite enormous injections of liquidity by central banks everywhere.
The top 8 central banks of the world are now sitting on bloated balance sheets holding mostly fixed income securities in excess of US$16 trillion collectively, more than twice their asset-volume before 2007. They got there mostly by swapping cash for bonds -- courtesy of Quantitative Easing, or QE -- as they tried to bolster the reserves of commercial banks which were hesitant to extend essential business credit, afraid that a new wave of illiquidity would expose them to potential bank-runs.
The fact is that over the last three years, thanks to globally coordinated central bank intervention, an unprecedented mixture of record-low interest rates combined with the abundant liquidity of QE has indeed bought most banks enough time to appease their insolvency fears. That was the good news. The bad news is that it did not eliminate them; at least not yet. As they say in the medical world: the operation was a success, but the patient must still stay under close supervision.
For banks, insolvency is not to be confused with illiquidity. The latter is running temporarily short of cash. The former is the chronic inability to predictably service a debt load stemming from inadequate capital-levels unable to support deteriorating asset quality. In this last case QE can’t be of much help. Greece is a poster child of sovereign insolvency that increased liquidity couldn’t rescue. And, for reasons to be detailed below, it looks like they won’t be the last either.
Revisiting the Great Recession
Since 2007, what originally started as a housing bubble in the United States and the United Kingdom quickly became a widespread credit crunch; was followed in September 2008 by an unprecedented crisis of confidence in world’s banks, central banks and the governments behind them; was later succeeded – and still is – by sovereign debt worries for advanced economies, while inevitably pointing to the next waves of uncertainty: exchange rates and globalization.
Rarely have economic crises -- undoubtedly among the few certainties in life -- managed to confound so many people, in so many places, so much and so long. Yet, to everyone’s dismay, the thrill goes on.
To illustrate the range of damage, what was once hastily estimated to cost some $500 billion to the US sub-prime lenders has gradually evolved into recent history’s largest and most brutal financial asset destruction story, erasing 30% of world’s GDP at its low point in March 2009. This has occurred in a world where sophisticated computer models, hedge funds and innovative financial products were all expected to mitigate risks and better cushion the impact of shocks.
Three years later, having retraced 2/3 of these losses worldwide, “deleveraging” still remains as the only imperative for the developed world.
Alas, it still appears elusive for each and every advanced economy as they have all tacked-on more public-debt to avert the nefarious effects of deflation. No advanced economy has yet won the battle against the “phobia of deleveraging” because of the inherent risks in curtailing, eliminating or even negating economic growth.
Moreover, since 2007, growth in government debt has eclipsed the reduction in private sector debt in just about every rich country, further deferring national deleveraging to a later time. Hard to tell political procrastination from electoral capitulation, but does it matter which? To use another medical analogy: the patient, who could not lose weight (or debt) despite being told it was a matter of survival, has pinned all hopes instead on “giving time yet another chance”.
The Financial Fitness of Nations
The Bank of International Settlements (B.I.S) which acts as the central bankers’ bank worldwide, was so concerned about the level of public and private debt accumulating in the developed world that in 2011 it undertook some pointed research in that direction. More specifically, it wanted to establish some thresholds beyond which the burden of debt would damage growth.
Their empirical analysis has established that public debt in excess of 85% of GDP puts a country at risk of default. In the same vein, it set the corporate debt threshold at 90% of GDP and the household debt threshold at 85%, for a total of 260% representing the total debt-to-GDP level at which growth is seriously hampered. (Curiously, they left financial sector debt out of their study. Whether it was because highlighting the reckless overleveraging in the financial sector as the primary culprit of the Great Recession would be politically too-hot to handle, or some other peculiar reason, remains a mystery.)
Then they go and document that some 30 years ago, in 1980, the weighted average of the total debt-to-GDP for all of the 18 OECD economies stood at 169%. Thirty years later, in 2010, that number had jumped to 306%, way above the 260% identified earlier as a “growth killer” threshold.
For purposes of comparison, albeit empirical, let’s pick 10% below the growth-killer threshold ( it comes to 235%) as the number above which a county is no longer considered to be “financially fit”. Simply put, this becomes the maximum reasonable debt burden that a nation’s combined Private and Public sectors can carry. That, of course, needs to be supplemented with the exact components of that debt, national economic growth-prospects, competiveness, and demographic evolution, as they all provide for a more complete country-specific context in evaluating its sustainability.
First-pass Scoring
This preliminary look, will present the B.I.S. supplied information to do some comparisons, noting however a huge caveat: without including financial sector debt, this is like taking the patient’s temperature alone to evaluate his overall health condition – can be dangerously misleading.
At first brush on the snapshot below, two observations are appropriate: a) no single country is comfortably below the “growth killer” threshold, although Germany and the US are close; b) Greece and Italy look like they are better than most others, inviting immediate closer scrutiny as to why ?
Upon closer examination, with the 30 year history below, things look quite a bit different.
Firstly, Canada sticks out in the sample as a role-model for not letting debt outdistance GDP growth, closely followed by the Netherlands as another good example of restraint.
Secondly, Japan the outcast, redeems itself for having kept a relatively good lid on debt since 1980.
Thirdly, both Germany and the USA look like they are in a comparatively manageable position for reining-in their runaway debt loads.
On the other hand, Greece, Italy, Portugal and Belgium all clearly show signs of debt overdose, without even knowing if their financial sector exposures will further exacerbate their overall condition.
Finally, Spain, UK and France all share some “debt pains”, but it is not clear without a closer look if they should be admitted in our so-called “intensive care unit” anytime soon.
Second-level Assessment
Digging a little deeper to examine the leverage-levels in banking for these nations will prove to be a lot more revealing. This should not come as a surprise, because dissociating sovereign-debt problems from the credit capacity of a country’s own banks (as the first-pass scoring has done) is like disassociating the patient’s X-ray from his blood test results : largely inconclusive and potentially misleading.
However, our job is a little more difficult to do because Europeans and Americans present the data differently. In the US the Fed, as the central bank, periodically publishes the level of debt carried by the financial sector in its quarterly statistics. In Europe, by contrast, the ECB presents the total bank assets by country without explicitly reporting their debt-levels. They can be reasonably inferred, however.
In the US, the government has been unquestionably successful in deflating the financial debt-bubble that erupted in the last decade. From 2008 to 2011, financial debt relative to GDP has dropped from a treacherous 120% to a more realistic 90%. That was the good news. The bad news is that the gross public debt has climbed instead by almost the
same amount, still leaving a total national debt-burden well in
excess of
350% of
the American GDP. Deleveraging at the national level is yet to take place in the
USA: shifting the debt-load is not quite as shrinking
it.
But
the US is in a rather good spot: if its economy could be invigorated to create
more jobs, then its government deficits may be curbed faster than other
nations’. Its demographics and productivity are favorable, if not even enviable
among all other OECD countries.
Yet, that will need fiscal policies that compensate for the lax monetary policies of the last 20 years. Without acknowledging that reality and taking corrective steps, its public debt will be facing questions similar to those raised against the European sovereign nations in crisis.
In Europe the situation was, and still is, rather precarious as financial debt clearly aggravates the prospects for a speedy recovery, even for Germany, assumed to be the growth engine. Let’s start with Germany.
With total bank assets north of 300% of GDP, financial sector concentration is about three times as much as in the US. Abstracting bank-leverage sustaining these assets from the German sovereign debt-capacity is simply naïve . As we have seen with the case of Dexia( Belgium) or ING (Netherlands), when so called “global banks” face insolvency, the rescue package doesn’t come from far away but from the national governments harboring them. So, the exposure of governments in the EU to outsized banks with vast global operations and assets cannot be simply dissociated form the public-debt capacity that has empowered them in the first place. That also applies to the leader of the pack: Germany.
France is clearly in the second best position in the EU with an overall profile not too far away from Germany’s, except for oversized corporate debt. This is fine. Of all the places debt could bulge in a country, the business sector is certainly where talented management combined with productivity could make a difference the fastest. South Korea is a vivid example of that.
Italy comes in as a surprise with a relatively smaller concentration in banking and hence a sovereign debt-load comparatively more shielded from another global banking crisis. This reinforces the prevailing view that Italy’s problems depend on lowering labor-costs and more structural reforms for reducing government deficits and, over-time, its sovereign debt-load. Italy is unlikely to be “Greece” anytime soon, especially with Mario Monti as its prime minister.
Spain on the other hand, suffers from two large disadvantages in comparison to France : a massive concentration in the banking sector making them susceptible to increased solvency risk and, a massive corporate debt-load at twice the GDP facing uncertain domestic demand resulting from a record 20% unemployment. Radical changes with a new government focused on labor laws and labor costs will help, but will it be enough to prevent getting worse is far from clear, as already manifested by their pre-announcement of missing their 2012 fiscal targets.
Portugal, already singled out in the first-pass as a problem case, only confirms the gravity of its situation with a relatively large banking sector that leaves little room to manoeuver.
Netherlands and Switzerland, understandably the two most active countries with financial reforms and bank re-capitalizations in Europe, are in comparatively good fiscal health: it helps!
Of all the countries in Europe, the United Kingdom stands alone on an island (literally) as the one with the most dangerous exposure to the vagaries of finance. Not only its consumer and business debt is comparatively large, but it also carries an inordinate level of foreign debt, four times the size of its GDP. The IMF recommends that external debt be kept under 100% of GDP, unless the country has a large trade surplus. If Greece has succumbed to runaway government debt, Britain’s largest challenge is its overwhelming exposure to the risks its banks carry.
The problem is that British banks are too-big-to-save, even after the reforms that have been proposed for segregating commercial banks from investment banks while ring-fencing them. The only saving grace for the U.K. is its independent currency which is free from the Euro “straightjacket”. Continuing to debase the Sterling, as has been the case for the last 40 years, does come close to gradual deleveraging but it affects all citizens, not just the overleveraged banks. This obviously reduces the chances of improving national prosperity for the once prominent world superpower.
Concluding remarks
No, it is not the disastrous bankruptcy of Lehman Brothers alone that wrecked world’s financial order. The damage, albeit serious and brutal, could have been better contained if the richest nations of the Western World had not seeded systemic instability through three mistakes: overreliance on lax monetary policies for economic growth, grossly imprudent fiscal policies and, last but not least, unclear accountability in the self-governance of the largest banks.
On second thought, it is not just a global financial crisis we have been going through, but the tremors of the remodeling of a new World Economic Order, with China leading the charge.
On the way to that new order it is important to realize that finance is not about the creation of wealth, but about its management. Wealth is created by matching capital with human ingenuity in the employment of productive labor. Over the last three decades those lines got blurred; wealth reshuffling got confused with wealth generation. These large "credit bubbles" facilitated excessive wealth-concentration and income disparities, encumbering the road to economic revival and dragging along unsuspecting governments into the untold traps of public-debt.
How will developed nations, currently saddled with excessive debt, rising unemployment and lackluster growth, will compete with developing nations in their quest for restoring prosperity will undoubtedly shape the first part of this century. Clearly, improved financial fitness through deleveraging is going to be a critical and necessary first step in that direction for all rich nations.
What is still unclear though is whether deleveraging can be realized without crossing paths with some deflation. If the answer is negative, then QE, although successful at preventing bank insolvencies, would have deferred the inevitable, delaying a durable recovery by a few years.
It is still too early to declare that the Great Recession is behind us.
