The Winds of Change

Since first starting to write on the economy I have slowly developed a picture of the world economy, and that picture has alarmed me. As I wrote recently, it is a picture in which policymakers have an illusion that they are in control, but a reality that they are not really able to predict the consequences of their own actions within a dynamic and interconnected system.

I have also long highlighted the problem of the use of GDP figures, on the basis that they do not really signal anything of value in relation to the underlying health of the economy. All the figures provide is an illusory sense of comfort, in which borrowing by governments and consumers, as if by magic, is recorded as income. A typical example can be found for the UK on the BBC news website:

The National Institute of Economic and Social Research (NIESR) predicts that the economy returned to growth, bringing an end to the recession.

[and]

NIESR said the pace of growth appears to be increasing. It estimates that there was a 0.2% increase in GDP in the three months ending in November.

The fact that the 'growth' is accompanied by massive government fiscal deficits is not apparently an issue. I sometimes feel that I am repeating myself endlessly in highlighting this problem, but the trouble is that it will not go away. GDP 'growth' is widely believed to signify that an economy is moving in the right direction, and it is believed by policymakers, economists and (of course) much of the general public. Even as governments rack up ever more unsustainable debt, analysts scrutinise every minute shift in this largely useless metric.

There are many excuses made for fiscal profligacy made on behalf of governments. There is the idea of stopping a 'downward spiral'. The argument goes like this; if we can only spend enough, then we will put money in the pockets of consumers, and they will continue to shop, and continue to pay their mortgages, and this will halt the downwards spiral. The reason for the problem, which is that (in aggregate) nations were spending more than they were earning is ignored. The solution is, in the end, founded upon an idea that it is possible to borrow and spend your way to wealth. Note, not borrow to invest, but borrow to spend.

One commentator on the blog insists that government debt is different to personal debt. For example, the suggestion is that government debt is supported by the tax base, and the size of the tax base is large enough such that, if need be, the money might be repaid. This is the argument that government might put money in consumers' pockets to save the economy now, only to take more out of their pockets in the future. This will happen, of course, once the economy returns to 'growth'. The 'growth' that is created is, of course, the 'growth' created by government borrowing and spending rather than the kind of growth that will lead to exports and a return to current account surplus.

It seems that the policymakers recognise this, as lax fiscal policy is accompanied by lax monetary policy, including printing money. This serves to debase the value of currency, and allows for the (potential) rebalancing of trade, and the erosion of the value of debts held in the devaluing currency. It is the hope that governments might borrow and then stealthily default on the debt by reduction in the value of the debt. The fiscal stimuli act to tide the economy over and the intention is that the true value of the debt will never be repaid. As the country emerges from the crisis, as exports once again pick up, all will be well as the debt is repaid in currency that is devalued and export growth will pick up the slack.

That is the theory, but no policymaker speaks of it openly.

The problem is this; the policy can only work if the providers of credit are willing to be duped. That is the essential flaw in the policy. To date, the governments following this kind of policy have gotten away with it so far, and I am thinking of the UK and US in particular.

I have talked about the steady erosion of belief that is the foundation of these kinds of policies. It is the belief that the rich world countries will always be rich - that one way or another the wealth will always be there as if by some divine right. The rich world has always been rich, and always will be. This is simply a question of belief, and has no logical or empirical foundation.

Wealth is something that is created through hard work, dynamism, creativity and investment. It is achieved by out-competing the competition. There are many ways in which this might be achieved, but nonetheless, it is the bedrock of wealth creation. It is the aggregate of each individual's contribution within the economy to the creation of value.

What wealth creation is not is borrowing to spend, or creation of money with no foundation in an increase in output of value. Both of these are illusions of wealth, although the former might allow for a sense of real wealth for a while - if the country can get away with not repaying the money. As an analogy, we might think of a person borrowing to finance going on an expensive holiday. They really gain the benefit and enjoyment of the holiday whether they do, or do not, repay the loan that funded it. The fiscal profligacy of governments is providing the benefits in the hope that the full cost will never need to be repaid.

The problem is this; governments have promised their electorates that the 'holidays' are permanent, that we might continue with the lifestyles financed by borrowed money. Even as they are making such promises, they are quietly and surely defaulting on their borrowing. As I said earlier, the whole edifice rests upon creditors being duped. They must continue to believe that being paid in devalued currency is an acceptable deal.

The illusion really is coming to an end now and this is the reason for this post. The continuation of the policy maker's game all hinges on 'belief'. That belief is now being eroded as, day by day, more and more questions are being raised about what the policymakers are doing. The expression 'sovereign default' is appearing ever more frequently, and the policy maker's economic flim-flam is starting to be being seen for what it is; a fraud. I have just been reading the World Economic Forum's (WEF) report on the risks within the global economy. The following quote is of note:

The worst case scenario of overlapping economic recessions with political instability and social turbulence, triggered by untenable fiscal deficits and unsustainable government debt burdens, might not, after all, be impossible.

In their highlighted risks section, they say the following:

In response to the financial crisis, many countries are at risk of overextending unsustainable levels of debt, which, in turn, will exert strong upwards pressures on real interest rates. In the final instance, unsustainable debt levels could lead to full-fledged sovereign debt crises.

They express particular concern for the UK and US, saying that "Governments, in the US and the United Kingdom in particular, are now faced with a set of tough choices, all with consequences for future global risks." They highlight the increasing of structural costs, such as the ageing of populations, and the absolute necessity for credible plans of how the fiscal deficits might be reduced. They point out the problems with formulating such plans; that the politicians need the courage to tell their electorates of the tough choices.

Their assessment of risk in reality hinges upon the idea that countries like the US and UK are living beyond their means. They are borrowing more than they can repay, and the only way to resolve the situation is for the countries to live more modestly (if you can excuse the metonymy). In saying this, they are replicating the argument that this blog has made from the first post.

The WEF is not alone. Many others are expressing their concerns, such as Nouriel Roubini. In a recent article in Forbes, he says the following:

The severe recession, combined with a financial crisis during 2008-09, worsened the fiscal positions of developed countries due to stimulus spending, lower tax revenues and support to the financial sector. The impact was greater in countries that had a history of structural fiscal problems, maintained loose fiscal policies and ignored fiscal reforms during the boom years. Going forward, a weak economic recovery and an aging population is likely to increase the debt burden of many advanced economies, including the U.S., Britain, Japan and several eurozone countries.

Roubini highlights the risks for countries such as the UK and Spain for sovereign default, but suggests that the reserve status of the $US will allow it to be amongst the last of the 'at risk' countries to face 'investor aversion'. I am not so sure, but believe that, if a country like the UK defaults, the initial reaction will be to flee to the 'safe haven' of the $US, before a rapid realisation that this is jumping out of the frying pan into the fire.

Roubini and the WEF are just some of the increasing number of analysts who are questioning the activities of policymakers. The voices talking of the unsustainable deficits are increasingly loud, and they will be making an impact. The nerves of investors in sovereign debt will be jangling. It is no longer just bloggers such as myself who are raising these concerns, but commentators with high profiles.

In my mind, it is just a question of timing now. When will the dominoes start to topple? It is still possible, in principle, that crisis might be averted. It is possible that the policymakers will pull back from fiscal irresponsibility. It is possible, but looks increasingly unlikely. They have promised to 'save' their economies. The big questions now are the questions of when it will start, and what will provide the push.

Note: At the start of last year, I made a prediction of crisis for April, and was proved to be completely wrong. The underlying principles I highlighted were the same as here. Why might I be right this time, when wrong before? The problem in my first discussion was that, I had simply not factored in the strength of 'belief' in countries like the UK and US. A sovereign crisis requires loss of belief in the creditworthiness of the country, and that belief has proved to be far more resilient than I imagined. It is why I have emphasised the high profile of commentators who are raising the concerns. It is more difficult to shift firmly held beliefs than I thought, but nevertheless it is possible for belief to shift. I believe that the process is now rapidly advancing.