Low interest-rates do not encourage deleveraging

The Paradox of Low Interest Rates

Cheap credit is hindering deleveraging, along with economic growth

At the low-point of the Great Recession, in March 2009, when $30 trillions of global wealth vanished inexplicably, central bankers of the world converged on a clear prescription: “deleverage, you must!” was the unarguable path to alleviate the unprecedented levels of debt carried by rich countries.

The deleveraging imperative, or the necessity to shed some weight from the financially overburdened nations, became the new mantra. Central bankers, starting with the Fed and later accompanied by the ECB and others, thought they had figured it out: by dropping interest rates as low as possible they would facilitate debt reduction or rescheduling and, also, prevent an economic contraction, in the hope that conventional growth would ensue. They also taught inflation wasn’t a threat, but rather deflation was.

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. Their research suggested that a total-debt-to-GDP ratio of about 260% would seriously hamper economic growth. Furthermore they went on to document that for the 18 OECD economies, the well-off nations of the world, that ratio stood at 169% in 1980 (ex-financial sector debt), significantly below the 306% “growth-killer” attained in 2010. “Deleverage, or else”, couldn’t have been clearer, especially for countries like Greece, Italy and Portugal whose debt outdistanced economic growth over a long 30 year stretch.

Moreover, in 2009, the distribution of the excessive debt itself varied from country to country, much like excess weight that accumulates in different parts of the human body. Certain countries like Italy and Spain had their business sector overextended with debt, Japan and Greece were top-heavy with accumulated government deficits, while the US, UK and Netherlands stood out with overstretched households and overexposed banks.

The European sovereign debt crises that followed in the next few years confirmed once more that government debt reduction was the hardest type of deleveraging there was. Without tax increases, assisted by other relevant reforms, this one was hard to shrink.

Ironically, the B.I.S study had excluded the impact of financial sector leverage – the primary culprit of the Great Recession on both sides of the Atlantic – from their analysis. In other words their model was a best-case scenario which assumed that all financial institutions that destabilized the global system would all deleverage in a hurry for their own sake.

So, where does the world stand now with the deleveraging imperative? The answer is unquestionably worse off. According to the International Center for Monetary and Banking Studies based in Geneva, world’s total debt-to-GDP (ex-financials) has climbed about by as much after the Great Recession than it did in the 7 years preceding it, straight up -- without even a brief pause! Moreover, emerging markets have also been joining the chorus, with China in the front row, for credit growth surging well above economic output growth.

Well, what about banks and other financial institutions? It doesn’t look good there either: with the notable exception of the US, most of the big banks in the EU remain “too big to bail”, while Chinese banks are working overtime to increase business and consumer loans. For cynics, the global economic crisis is seemingly morphing into a global leverage crisis.

Yet, America stands out slightly ahead in global deleveraging, with a measurable reduction in the debts of its Financial and Household sectors. However, that was accomplished at two costs: incremental public debt in excess of $5 trillion by 2014 – representing an insidious liability transfer from the private sector to an ill-prepared and unsuspecting government – combined with the burden on its central bank, the Fed, which ended-up with $4 trillion of bonds as the collateral risk associated with the still inconclusive QE programs.

Alas, it seems that the valuable lessons from Japan’s 20 year-long struggle to overcome stagnation with cheap and abundant credit are not being heard: QE and ZIRP just buy time to get debts and deficits in order, but they do not eliminate them. The latter requires true economic value creation and not just monetary policy tricks. One paradox of cheap credit is that, in perverse contrast with expectations, it did not induce aggregate debt reduction but its continued accumulation in just about every country in the world.

What about the goal of stimulating economic growth? You wish. After almost seven years, and despite exceptional measures with record-low interest rates augmented with QE monetary experiments by many central banks, it is still unclear that the path to sustainable growth for the rich countries of the world has been found. Furthermore, the sovereign debt of a few rich countries still contain significant risks, signaling more disruptions ahead.

The outlook for growth isn’t much promising in the US either: not only is there no magical turnaround, but excessively low-cost credit has already demonstrated to widen income distribution disparities to undesirable levels, weakening thereby broader consumer spending on which the recovery so desperately depends. And therein lies the second part of the paradox: negligible interest rates seem to hamper economic growth, instead of promoting it.

By now it is clear that, on the back of a failed deleveraging process everywhere, repressing savers with negligible interests while inviting financial asset-based inflation – primarily record equity values, levitated by investors’ thirst for higher yield at the hidden cost of heightened risks – have proven unlikely to generate nationally constructive business investments, increased consumer spending or improved confidence about the future anywhere – all essential ingredients to sustainable economic growth.

When will the rich countries of the world, starting with the US, realize that the prosperity of nations depends more on smart policy choices than experiments with monetarism?

Indelible Lessons from the Great Recession - Introduction

A recession unlike any other

Since August 2007, what originally started as a housing bubble in the USA and Britain quickly became a widespread credit crunch; was followed in 2008 by an unprecedented crisis of confidence in world’s banks, central banks and the governments behind them; was later succeeded by sovereign debt worries for European  countries previously thought to be prosperous and dependable ; unveiled shortly after persistent  frictions on the setting  of global exchange rates and the adequacy of bank capitalizations; and is now  increasingly looking like it will lead to trade conflicts which can inevitably alter the rules of globalization.

In recent memory no other economic crisis managed to confound so many economists, bankers, businessmen and government leaders, in so many countries, so much and for so long. This one hasn’t just caused massive global financial instability, but it will also be remembered for laying the foundation for the emergence of a new world economic order.

Seven years after the crisis, all of the G7 countries representing the advanced economies of the world are unmistakably flirting with deflation.  Even Germany, which best weathered the shock among the G7, is now facing economic stagnation courtesy of  unfavorable currency fluctuations combined with deteriorating demand in its own home turf of Europe.

The Great Crisis of 2008 has had devastating consequences worldwide. But its impact on America has been brutal, comparable only to the economic damage of the Great Depression. Although a global consensus on the causes behind the Great Recession has been particularly difficult to reach, three factors appear to create convergence everywhere:  excessive household debt, overleveraged financial sector and breakdown in accountability (both in the supervisory regulations and the corporate governance of big financial firms) to control an “overdose” condition in the previous two.

All three factors were present to varying degrees on both sides of the Atlantic. The question of “to what extent has lax monetary policy also contributed to stimulate the presence of all three?” is, rather remarkably, still unanswered.

Against this backdrop, there still remains however a few questions of major consequence. Attempting to answer some of them could provide valuable lessons for the future:

• When bubbles stemming from lax credit burst, as in 2007, who gets hurt the most?
• Why free-flow Global Finance, a once hailed concept, hasn’t averted the recession?
• Why is global deleveraging, a post-recession imperative, still very much deferred?
• Can monetary policy geared to currency debasement deliver economic growth?
• Why are all the rich economies of the world struggling with growth renewal?

Unfettered Global Finance carries untold domestic risks

A few months after October 2008, following Lehman Brothers’ unthinkable and calamitous bankruptcy, there were a number of explanations, both from academia and political circles, suggesting that free trade, combined with the free-flow of capital in deregulated global financial markets, would be most helpful in coping with the severity of this crisis.

Not only was that naïve, but it overlooked the fact that globalization had clearly changed the rules of the game and sacrificed predictability along the way. With persistently large trade imbalances combined with salient differences in financial regulations or banking laws and business practices across the globe, suggesting that we now had an increased capacity to manage worldwide instability was plain wishful thinking. 

For starters, banks that have been operating globally with vast cross-border operations were primarily European in origin. What set these banks apart relative to their American counterparts was their outsized assets compared to the economic output of the nations that harbored them. As the Swiss and the Dutch quickly discovered, having large universal banks with massive and disproportional global operations posed bigger national risks than originally understood. Yes, Citibank had to drastically curtail its global presence and reach after the crisis, but in a less dramatic way than the government-mandated retrenchments or reorganizations imposed on companies like UBS, ING and a few other European banks.   

 Euro Zone Financials: Still Too Risky

Seven years later, European banks still remain among the less well capitalized of the world with higher leverage ratios. According to the Bank for International Settlements’ latest report of January 2015, the majority of the 14 participating banks -- out of 31 worldwide – which reported that they will still be unable to fully comply with the risk management principles of the Basel Committee by the 2016 deadline were from the Eurozone.

Rephrased differently for simplicity,, should another banking crisis develop unexpectedly, some European megabanks are still inhabiting the riskier “too big to bail” universe.

What makes their job a lot harder is that deleveraging at the national level has not even started yet. After all these years, the combined private and public debt as a % of GDP has gone up, not down like in the US, for the entire Euro Zone, the U.K. and Japan.

COMPARING DEBT BURDENS: 5 years after the Crisis

Combined Private and Public Debts as a % of GDP

The significance here is that, as recently demonstrated once more by Greece, Euro Zone banks are still saddled with oversized sovereign credit risks which are still present in their balance sheets.

The untold lesson in this is that, unfettered global finance is a lot more unrealistic than previously believed. When the largest global banks faced insolvency in 2009, only one factor mattered in their rescue: their nationality. It was the Dutch, Swiss or British governments that saved their banks from possible extinction, and not the still non-existent global resolution authority for banking insolvency. So, lawmakers beware: behind the allure of profitable global banking operations lie the untold domestic taxpayer liabilities.

Credit Bubbles ultimately harm the nation as a whole

 

The Great Recession, although triggered by the US subprime mortgage crisis, has its roots elsewhere: that both America and Europe were living beyond their means.

Take the United Kingdom for example. According to its central bank, in the decade preceding the Great Recession, UK experienced the largest spike of household debt among developed nations, standing at an alarmingly high 200% of disposable income by 2009.

But Britain was not alone. Starting about 30 years ago and accelerating to precarious levels over the last decade leading to the Great Recession, insatiable appetite for credit has been widespread everywhere, especially in America and most of Western Europe.

Take the US as an example in the decade leading to 2007. According to the Federal Reserve, Household and Consumer debt outdistanced GDP growth considerably in those 10 years to reach $13.8 trillion by 2007, 57% above comparative levels of economic output. The same data also shows that Financial Sector indebtedness had surpassed $16.1 trillion by 2007, 78% beyond the level normalized to GDP growth over the decade. These two "bubbles", of about $5 and $7 trillion respectively, defined the implosive state of America's finances.

What happened in the 6 years that followed the Great Recession in the US is unmistakable. The Financial Sector deleveraged first -- fast and furiously -- slowly accompanied by the

Consumer, both shrinking to 80-90% of Debt to GDP, as a much safer range.

 

Components of indebtedness against U.S. GDP: before & after 2007 (Source: The Fed)

Although the total debt -- Public and Private, including Financials -- in all those years stayed around 350% of GDP, government debt ballooned by about $5 trillion, representing an insidious liability transfer from the private sector to an ill-prepared and unsuspecting government.

 

But the US was hardly alone to shift the burden of the Great Recession to the taxpayer, albeit a large one and in the surprising company of Ireland and Greece.
 

Incremental Government Debt: 2007 to 2012, as a % of GDP (Source: IMF, BIS)

The lesson in this that has not been explicitly drawn is that credit bubbles, manifested as excessive private-sector debt, hurt the whole nation when they burst. The victims are not just reckless borrowers or lenders, but also innocent citizens living within their means, along with all taxpayers, left with liabilities that they have never agreed to endorse. Enduring credit bubbles is like drug overuse: inevitably harmful and systemically weakening.

 

So, what should be done to better preserve the structural health of an economic system, especially if monetary policy is viewed as a credit "regulator" for the domestic economy?

The answer starts by accepting that if increasing money supply is helpful to invigorate a moribund economy, its timely reduction to avert overindulgence is also part of the job.

There are two obstacles however that stand in the way. One is the outdated mandate of the Fed preoccupied with inflation instead of the collateral damage from lax monetary policy.

The other is that deflating bubbles before they burst by restricting credit through higher interest rates is politically unpopular. This is why central bank independence is so critical.

The current dual-mandate of the Fed stems from 1977 when runaway inflation was a major political and social concern. Back then, price stability is all that mattered versus broader financial stability, which may include things such as the steadiness in currency value, or the frequency and severity of systemic shocks to the economy. By these last two criteria, the Fed's performance over the last 20 years has been especially controversial.

But is the real problem the Fed's performance or the misplaced expectations from its outdated mandate? Should the mandate for the Fed – the central bank behind world's reserve currency – be reworked to include broader financial stability, especially better and more dependable ways to predict and avoid severe shocks to the financial system?

The U.K. already serves as a good example of foresight in that direction by explicitly adding the financial stability mandate to the mission of its central bank, the Bank of England, with the Financial Services Act of 2012. Other countries like Canada and Israel also expect more from their central bank than monetary policy managed through setting interest rates. Their experience with mandating higher down-payment requirements to deflate speculative real-estate bubbles – instead of jacking-up interest rates – is especially noteworthy.

It seems the new vice-chair of the Fed, Stanley Fischer, is particularly attuned to the needs of reworking the Fed's mandate. By suggesting that Congress should consider making financial stability an explicit mandate for all U.S. financial regulators, he is pointing out the biggest need for change in American monetary policy: a mandate which should go beyond the management of credit and inflation to also include responsibility for financial stability.

Otherwise, former Fed chairman Alan Greenspan's well known suggestion of the "inherent inevitability of boom and bust cycles in monetary policy" is missing an important point: accountability. Pilots navigating in turbulent weather understand this notion rather well: it's the ability to predict and maintain aircraft stability in the sky that matters, not succeeding at a "soft landing" while escaping a storm which could have been avoided.

 

Indelible Lessons from the Great Recession

BACKGROUND & CONTEXT

A recession unlike any other 

Since August 2007, what originally started as a housing bubble in the USA and Britain quickly became a widespread credit crunch; was followed in 2008 by an unprecedented crisis of
confidence in world's banks, central banks and the governments behind them; was later succeeded by sovereign debt worries for European countries previously thought to be prosperous and dependable ; unveiled shortly after persistent frictions on the setting of global exchange rates and the adequacy of bank capitalizations; and is now increasingly looking like it will lead to trade conflicts which can inevitably alter the rules of globalization.


In recent memory no other economic crisis managed to confound so many economists, bankers, businessmen and government leaders, in so many countries, so much and for so long. This one hasn't just caused massive global financial instability, but it will also be remembered for laying the foundation for the emergence of a new world economic order.


Seven years after the crisis, all of the G7 countries representing the advanced economies of the world are unmistakably flirting with deflation. Even Germany, which best weathered the shock among the G7, is now facing economic stagnation courtesy of unfavorable currency fluctuations combined with deteriorating demand in its own home turf of Europe.


Yet, a lot has happened since March 2009 -- the low-point of the Great Recession -- when $30 trillions of global wealth vanished inexplicably. Since then most stock markets worldwide have bounced back from their historic drops, and some like the in the US or UK have even reached record highs.


Alas, appearances can be deceiving. Historically strong stock markets have always been associated with strong economies. To suggest that this time is different has to pass scrutiny, especially for two key assumptions sustaining the excitement: the lowest interest rates in generations are expected to deliver real economic growth worldwide and, investor hopes of oversized financial returns from equities, when compared to alternatives, are warranted.


Both of these assumptions invite natural skepticism. What if the exceptionally daring monetary experiments by central banks in the US and the EU were not able to deliver the longed-for recoveries in the rich countries of the world? What if the flirtation with deflation was not a fantasy, but a new adversity to prick the stock-market bubbles back into reality? After all, Japan is a living proof for both of these misplaced hopes for over 20 years now.


Inconsistent explanations behind the wreckage


In the weeks following Lehman's bankruptcy, when the US government was perceived as struggling to regain financial stability while still experimenting with how not to violate the moral principles of capitalism, investors everywhere ran for the exits: with assets prices dropping precipitously, over $12 trillion of world's financial wealth disappeared quickly.


By March 2009, six months after Lehman's bankruptcy, the financial damage was simply devastating. What had started as the US sub-prime mortgage crisis, originally estimated to cause about a $1 trillion of asset impairment to a number of careless lenders, had gradually evolved into recent history's largest and most brutal financial asset destruction story: at that low point, as much as 30% of world's GDP went temporarily missing.
 

Yet reactions and explanations were everything but consistent. Pinning the problem on the U.S. subprime mortgages – which was the first media reaction – failed to explain the severity and reach of this global contraction, which ended up all the way in Russia. After all, the latter had apparently no banks exposed to subprime or to other toxic paper.


The "mispricing of risk" argument proposed by former Fed chairman, Alan Greenspan, did not address the dangerous role that the "shadow banking" system — the non-bank financial institutions that defined deregulated American finance — played in this debacle. They, more than commercial banks with tight lending practices, are behind the $7 trillion excessive debt which ballooned in the U.S. financial sector in the decade preceding 2007.
 
"The failure of laissez-faire U.S. capitalism", suggested by the former E.U. President Sarkozy, did not illuminate how Europe's largest universal banks have been even more devastated. It is now widely acknowledged that, beyond U.S. investment banks and financial giants, the practice of reckless overleveraging was alive and well on both sides of the Atlantic. Those so-called European "universal banks" like UBS, Deutsche Bank, RBS and Barclays, to name a few, were surely keeping rival banking conglomerates like Citigroup and Bank of America in ravenous company.


The Great Crisis of 2008 has had devastating consequences worldwide. But its impact on America has been brutal, comparable only to the economic damage of the Great Depression. Although a global consensus on the causes behind the Great Recession has been particularly difficult to reach, three factors appear to create convergence everywhere: excessive household debt, overleveraged financial sector and breakdown in accountability (both in the supervisory regulations and the corporate governance of big financial firms) to control an "overdose" condition in the previous two.


All three factors were present to varying degrees on both sides of the Atlantic. The question of "to what extent has lax monetary policy also contributed to stimulate the presence of all three?" is, rather remarkably, still unanswered.


Against this backdrop, there still remains however a few questions of major consequence. Attempting to answer some of them could provide valuable lessons for the future:

• When bubbles stemming from lax credit burst, as in 2007, who gets hurt the most?
• Why free-flow Global Finance, a once hailed concept, hasn't averted the recession?
• Why is global deleveraging, a post-recession imperative, still very much deferred?
• Can monetary policy geared to currency debasement deliver economic growth?
• Why are all the rich economies of the world struggling with growth renewal?

 

The Impasse of Monetary Policy ( Summary)

 

Why The Fed, by itself, cannot deliver a sustainable recovery?

ABSTRACT

The Great Recession of 2008, after wrecking the balance sheets of the largest banks in the US and in Europe, ended up saddling the governments behind them with the most invasive fiscal deficits in recent memory. With gross government debt as a % of GDP sitting at precarious heights everywhere– the US at 105, many EU countries over 100, Japan off the curves at 245 – all hopes for stimulating economic growth were anxiously pinned on unconventional monetary policies, with the US Federal Reserve taking the lead among world’s central banks.

Six years later, despite exceptional measures with record low interest rates and unusually bold QE by many central banks, especially the US, it is still unclear that the path to sustainable growth for the rich countries of the world has been found. Furthermore, the sovereign debt of world’s largest countries remains a problem signaling probable “currency wars” ahead.

As importantly, it also seems that the lessons from Japan’s 20 year-long struggle to overcome stagnation with cheap and abundant credit are not being heard: QE and ZIRP just buy time to get debts and deficits in order, but they do not eliminate them. Not only there is no magic, but excessively low-cost credit has already demonstrated to widen income distribution disparities to undesirable levels, weakening thereby consumer spending on which the recovery depends.

There is little doubt that in most of the Western World structural reforms for attaining fiscal rectitude are politically challenging to pursue. But repressing savers while inviting asset-based inflation with exceedingly low interest rates have also proven unlikely to generate nationally constructive business investments, increased consumer spending or improved confidence about the future – all essential ingredients to sustainable economic growth.

The time has come for the rich nations of the world, especially the US, to stop abdicating to their central bank economic growth responsibilities which it cannot carry out on its own.

The Impasse of Monetary Policy - Part 1- Setting the scene

 

Why The Fed, by itself, cannot deliver a sustainable recovery?

 A 6  part series

 Part 1:  Setting the scene

   

1.     INTRODUCTION

                                              

America’s economic revival is hindered by a number of dubious notions, or untenable convictions. Chief among them is overreliance on monetary policy as a solution to all economic problems, especially restoring growth and employment after a recession hits.

Six years after the Great Recession of 2008, despite the extraordinarily low interest rates bolstered by aggressive Quantitative Easing (QE) for an unprecedented $4.5 trillion of bond purchases by the Fed, the recovery still looks curiously tentative, if not anemic.

·     Growth in 2014 was under 2.5 %, even if the second half of the year the economy expanded at a surprising 3.5% as to compensate for a measly 1.3 % growth in the first half. There are still too many unknowns to declare the last 2 quarters as growth-rate a trend setters.

·     Labor participation rate under 63% is at a 36 years low, pointing to about 10 million less people with jobs relative to 2008 when the recession was declared. This “slack” in the labor force, despite an unemployment rate which finally dropped below the target 6 % in the 4^th Q of 2014, continues to trouble Fed’s chair Janet Yellen who described her concern at the most recent Jackson Hole conference.

·     Inflation is unresponsive and tracking below 2% despite the unparalleled QE programs pumping many $ trillions of liquidity into the capital markets. Alas, the outdated and restrictive way by which inflation is measured may well be masking a looming problem: the unavoidable impact of both the record rise in stock prices and the large appreciation in house prices since 2009 is omitted from the inflation index.

·       Consumer spending which accounts for more than 2/3 of U.S. economic activity is still inexplicably muted, despite the cheapest borrowing rates in recent memory and the vast household debt reduction, from 98% of GDP down to a sustainable 81% now. More mysteriously, rising stock markets, historically associated with increased household outlays, have this time failed to stimulate higher consumer spending.

·     Deleveraging, an imperative for financial stability, is still a mixed-bag: while private-sector indebtedness has decreased to historically sustainable levels of around 80% of GDP, gross public debt, now over 105% of GDP, is a daunting obstacle if renewed recessionary fears do indeed engender increased government spending. 

Even more unsettling is that the Great Recession of 2008, which is still playing out with an abnormally lackluster recovery, still faces the same and yet unanswered question that followed the 2001 crisis: to what extent can  expansionary monetary policy – undeniably  correlated with asset and credit “bubbles” –  also repair the damage that it helped create ?  

1.    TAKING STOCK OF THE CURRENT  SITUATION

2.1   Discarding some misconceptions first

Political discourse in the US projects unmistakable signs of confusion when references are made to either John Keynes or Milton Freedman. In the first case, Keynesian economics is criticized because of the incremental burden that increased government spending imposes on taxpayers; while in the second case, Milton Freedman’s monetarism is feared because of the inflationary risk that increasing money supply poses in support of a faltering economy. Both theories contain so many nuances and conditions that, in the absence of correct contextual clarity, condemning them is not difficult to do. Yet, the reality is quite different.

No, since 2008, the US economy has witnessed neither an alarming Keynesian rise of excessive government spending, nor an inflationary overdose of monetarist money supply.

 

We have witnessed instead, in the first case, record government deficits resulting from shortfalls in tax receipts that economic recessions bring – this time, further aggravated with misguided tax-cuts already in place – and, in the second case, a daring experiment with monetary policy which – fortunately for incredulous politicians and the public at large – succeeded in preventing the insolvency and decomposition of the US banking system.  

To be clear, a massive increase of Keynesian government spending to bolster economic output – by targeting public works for instance, as was suggested by Paul Krugman and others – has not yet taken place amid our political stalemate. And, inundating the economy with excessive money as to “inflate the deficit away” through currency debasement has not taken place either; the Fed’s swapping of cash with bonds through QE has indeed increased the monetary base, but not the kind of money supply associated with massive devaluations.

But now here we are, six years later, with an uncertain economy and a tentative job market, wondering whether and how the anticipated but still elusive growth will suffice to eliminate chronic government deficits and a threat of deflation, both of which are stubbornly present.