A personal perspective on the economic crisis
Economic crisis, turmoil in Europe, debt management activity across Western economies and the resulting impact on the Global financial system has pre-occupied the news media over the last two years. There is still no respite for political leaders and the focus in the European Union, as elsewhere, is to identify how best the Euro zone can support debt laden Greece and other Euro-zone members caught up in the developing crisis of confidence. It’s hard to imagine any modern day commercial enterprise being able to survive with the current levels of indebtedness of key Western economies – where almost all G7 members have greater than 90% debt to GDP, some considerably more than 100% of GDP – and this despite the existing constraints on Euro zone signatory compliance with the Maastricht Treaty. It’s now widely recognised that if World leaders are going to address the economic crisis, they will need to resist making short term gestures that ultimately make things worse. In large part the measures taken to resolve the banking crisis in 2008, in isolation of implementing other changes, have contributed to the economic crisis in Europe and the US today. A crisis fuelled by sovereign debt, waning investor confidence, Globalisation, and negative/stagnant economic growth.
What are the issues in Europe, and how are they relevant?
The most pressing issues relate to the challenge of how to:
- reduce massive budget deficits without depressing the Global economy and creating social turmoil
- avoid the break up of the Euro zone
- stem the crisis of market confidence in sovereign debt repayment
- maintain solvency and liquidity in the banking system in the face of wide scale debt default
- stimulate economic growth, increase employment, maintain an effective regulatory environment for business and finance in the future, and balance the benefits of a free-market model of capitalism with social-responsibility and global competitiveness.
The scale of the unfolding problem is unimaginable. Even after writing down half of its Sovereign debt, Greece still can’t shoulder the interest burden and reduce its debt. Further write-downs are unavoidable since the financial burden is simply bigger than the failing Greek economy can support in any meaningful timescale, and regardless of other challenges. This situation has pushed up bond yields and created market volatility that will eventually force Greece out of the Euro zone, cause it to default on its debts, and create financial stress to the European banks holding its bonds. Even though this eventuality is widely anticipated, it will still create turmoil in the global banking system and further impact economic growth.
Worse still, Italy (three times the combined size of Greece, Portugal and Spain) is also under tremendous pressure, with Sovereign debt an eye watering 120% of GDP, or 1.9 trillion Euros. The consequence of Italy defaulting on its debt is unthinkable. French, German and UK banks collectively hold about €400 billion of Italian bonds. Failure would threaten their solvency and cause a seismic shock to the World banking system. With volatile market sentiment, Italy’s bond yield has repeatedly burst through the critical 7% threshold, where annual interest payments are a staggering 350 billion Euros, or approximately 40% of GDP. Italy’s yields remain highly sensitive to general market sentiment.
Repeated effort across Europe to address the situation has had little lasting impact. On each occasion, initial improvements in market confidence quickly dissipate, as the challenges of developing a solution quickly enough to make a difference are understood. Neither is there agreement about approach. Currently there are two schools of thought; neither is devoid of its issues –
Austerity measures – budget management. Problem – convincing large populations to support decades of increased taxes and severe austerity measures will not pass smoothly. Resistance is already significant as resentment of deep-rooted economic inequalities, and widespread frustration with the political class boil over. Athens and other European capitals burned throughout the summer of 2011. More unrest is inevitable as the full impact of austerity is realised. No wonder the UK Government is making early preparations, spawning news headlines like “More Metropolitan Police to be trained in baton rounds”, [BBC News].
Economic growth – Keynesian style state intervention injecting cash into the economy by infrastructure investment Problem – this requires already indebted governments to borrow more and assumes that the money will be widely distributed so as to stimulate economic activity.
In this heady climate of crisis resolution, maintaining liquidity in financial systems and executing the budget deficit reduction activity needed to recover market confidence are foremost on the agenda of political and financial leaders – acutely aware that what needs to be done to save their economies will be deeply divisive and damage their future political ambitions.
This sets the scene for the economic maelstrom heading our way should: credit rating agencies continue to downgrade ratings of key European economies, investors flee Sovereign bonds, bond yields escalate to unsustainable levels, contagion sweep through the banking system causing money circulation and credit to dry up, the global economy sink further into recession creating mass unemployment, and/or widespread social unrest in populations with little to look forward to for generations to come.
Is there a fix?
Some believe the solvency and liquidity issues can be addressed if the Central Banks print enough new money – as they did in 2008 with the onset of the banking crisis, and as the US Federal Reserve has been doing ever since. There are two flavours of this, ‘Credit Easing’ and ‘Quantitative Easing’ (QE). In the former, the Central Banks print money and lend it to banks at preferential interest rates hoping that this will increase lending between banks and therefore stimulate money flow. In the latter Central banks print money simply to increase the amount of cash circulating in the financial markets thereby increasing liquidity and solvency. Unfortunately there are problems associated with both, as the Germans are keenly aware. When Germany last printed money to stimulate its economy, the resulting hyperinflation was so severe the economy collapsed and created the circumstances that gifted Hitler his political platform. It’s therefore unlikely Angela Merkel will support substantive QE in the Euro zone – unless it is to negate financial catastrophe for Germany itself.
Printing money may provide short-term relief to: easing pressure on liquidity, supporting banks exposed to default, buying time to allow debt reduction plans to gain traction, and perhaps helping to calm volatility in financial markets. Beyond this, it causes other unwelcome problems, like: severe inflation, currency exchange issues, loss of international competitiveness, and spiralling trade deficits.
If Governments are already having difficulty servicing and repaying their debts, the situation will only get worse as the global economy deteriorates impacting tax revenues, should investors flee bond markets and borrowing costs escalate. QE certainly won’t solve the problem of how Europe (and the US) got into this situation.
There is another issue. As new money is printed to keep financial institutions stressed by debt default, solvent, this money accumulates in bank vaults – thereby removing it from circulation. This is because banks exposed to debt default, or the risk of it, are forced to strengthen their balance sheets to cushion against losses – by increasing capital reserves. That’s why QE by Central Banks in 2008 didn’t negate the problems we have today. QE isn’t a solution to the problem of debt, it’s a solution to the problem of solvency and liquidity. Therefore, if the is the only tool used, the underlying issues will continue unabated and require ever increasing amounts of cash with diminishing economic benefit.
There is little good news on the horizon. Euro zone economies will not avoid depressing growth in GDP while implementing austerity measures. Nor are they likely to be able to make adequate progress in reducing debt sufficient to satisfy the markets because the head winds are already too strong, and accumulating. Nor will they avoid (credit) rating downgrades and increased bond yields, or avoid challenges raising funds in future. Implementation of austerity measures will be hampered by a severe decline in social cohesion arising from the combination of budget cuts, loss of social benefits, and tax increases. Sooner or later, Greece will default on its debts and this will trigger similar failures with Portugal, Spain, Italy, Ireland and France. Thereafter the impact will wash through the Global financial system creating a spiral of increasing debt, decreasing money supply, increasing bond yields, inflation, and interest rates.
In fact, the rules that apply to an individual are the same for a nation state. If you can’t afford to service your debt and reduce it over time, you have to restructure it – or go bankrupt. Its not clear how seriously this is being discussed. The solution is almost too complex to be practical:-
Wholesale debt restructuring and/or write down of sovereign debt
Widespread exchange rate adjustment and devaluation
QE to maintain the banking system
Structural reforms to enable a balanced budget
Demographic shifts, urbanisation and growth in the E7
As if the financial crisis wasn’t problematic enough, there are underlying tensions that will further hinder growth, and therefore debt reduction efforts, beyond the immediate Sovereign debt and budget management challenges: –
- Firstly, although the Global population is set to increase to 9.3 billion by 2050, most of this growth is taking place in emerging economies – Brazil, China, India… In contrast, populations in Europe are in decline. Result – reducing consumption, reducing tax revenues and stagnant economic growth (GDP).
- Secondly, the populations of Europe are ageing, due to increasing life expectancy and reduced birth rates. This creates long-term difficulty for European economies. Result – fewer taxpayers entering the workforce, declining tax revenues, reduced consumption and increased public sector spending on social welfare and health care systems (or dramatically reduced benefits with budget cuts)
- Thirdly, offsetting declining populations across Europe’s stagnating economy, China will add around 400 million new, relatively affluent consumers to its existing urban population of 500 million. India is forecast to add about 300 million new consumers to its urban population. The impact of these changes to Global trade is significant. Currently the world’s seven largest emerging economies (E7) are about 20% of the size of the seven largest economies (G7) in terms of market exchange rates (MER), and 75% of the size in terms of purchasing power parity (PPP). By 2050 the picture completely changes and the current E7 will be 25% larger than the G7 in terms of MER, and 75% larger in terms of PPP. G7 economies are already being marginalised and the impact will create a structural shift as commercial enterprise realigns its distribution model with the new centres of trade. Although there may be some short to medium term relief with increased exports from the West to the East, this will be temporary and the shift in the main centres of trade will result in dramatic migration of jobs (from West to East) resulting in extensive job loss in all sectors except those that must be distributed locally. Result – declining tax revenues from reductions in the workforce and from corporations migrating to more efficient tax jurisdictions, increasing social welfare costs putting pressure on budgets, increased balance of trade deficits.
- Finally, dramatically reduced western economies will result in dramatically reduced financial markets and it’s probable that large corporations will relocate to overseas bourses. Prada is a recent high profile example, re-listing on the Hang Seng in Hong Kong. Result – severe impact on tax revenues for economies (like the UK) who are reliant on the financial service sector. David Cameron recently said that London (The City) was constantly under attack from overseas exchanges – trying to poach companies and the best City brains away from the UK. Unfortunately the tide is running against him.
These issues create significant (additional_ challenges for Europe since a drastically reduced and ageing population will create economic stagnation and increase pressure on public finances. Add to this the economic power shift from West to East, creating a migration of capital and jobs, and you have the makings of a perfect storm for Europe and the USA.
European corporations will hold their share of the global market but as time goes by many will re-align their business models, relocating their operations and even relisting on Asian bourses. In this scenario, one could imagine a radically different FTSE Index compared to the one we have today. Investors are unlikely to place their money in the shrinking, stagnating economies of Europe in preference to the rapidly growing BRIC economies where the returns are greater. The economic crisis in Europe will force portfolio evaluations and we will soon be hearing reports of investment funds rebalancing their investments.
Politicians can’t solve these economic problems without restructuring their economies and finding new ways to balance budgets against a back-drop of declining commercial activity, reducing tax revenues, and increasing pressure on social-welfare support. Restructuring and re-balancing an economy takes a long time. Re-educating a significant welfare dependent society and re-aligning its sense of entitlement is a long and traumatic process.
These scenarios are bleak and their impact will be felt across continental Europe and North America for decades. The European Union will fail and its unclear what will follow – disparate nation states with sovereign currencies and protectionism, or a new accord.
It’s a harrowing thought that while people are locked into the current financial system – banking, credit, mortgages, wealth management, property, etc – there will need to be something like a 50% reduction in living standards in order for Western economies to compete with those in the east.