The “least worst” option?
Western governments saddled with mountainous debts will “repress” creditors and savers via banking regulation, capital controls, central bank bond buying and currency depreciation that effectively puts sovereign borrowers at the top of the credit queue while simultaneously wiping out real returns for their bond holders. So says HSBC chief economist Stephen King in his latest report this week called “From Depression to repression”.
Building on the work of U.S. economist Carmen Reinhardt and others, King’s focus on the history of heavily indebted governments applying “financial repression” to creditors arrives at several interesting conclusions. First, even though western governments appeared successful in using these tactics to reduce massive World War Two debts alongside brisk economic growth during the 1950s and 1960s, King argues that the debt was cut mainly by the impressive economic growth and tax revenues during that “Golden Age” – and this was mostly down to the once-in-a-century period of relative peace that involved unprecedented integration and cooperation among western governments also engaged in a Cold War with the Soviet Union. Compared to this boost, the financial repression was a “sideshow”, he reckons. To show t
Instead, King says governments will adopt this repression tactic anyway just to stave off draconian austerity now and prevent a destabilising surge in economy-wide borrowing rates. This will effectively reduce the amount of credit to the rest of the private sector, or at least elevating its cost, while reducing the pressure on governments to cut the debt levels quickly. The net result, then will likely be “persistently lower growth”, whatever your conclusion about the desirability of state or the market allocation of resources.
And, in the absence of an obvious alternative, repression may also be the “least worst” option, King argues.
Three snapshots for Friday
Although the focus has been on Spanish debt auctions this week as this chart shows Italy has much further to go in meeting this year’s funding needs.
German business sentiment rose unexpectedly for the fifth month in a row in March, moving in the opposite direction to the composite PMI:
Greg Harrison points out 82% of S&P 500 companies have beaten their Q1 earnings estimates so far. It is early days but it it continues that would be the highest for at least five years. Is this a sign that the strength in corporate earnings in continuing? The chart below suggests as least part may be due to falling expectations coming into earnings season.
Japanization of euro zone bonds?
Fear of many years of stagnation in the major western economies has everyone fretting about a repeat of the “lost decades” that Japan suffered after its banking and real estate bubble burst in the early 1990s. Indeed HSBC economists were recently keen to point out that U.S. per capita growth over the noughties was already actually weaker than either of Japan’s lost decades.
But in a detailed presentation on the impact of two years of soveriegn debt crisis on euro zone government bond holdings, Barclays economist Laurent Fransolet asks whether that market too is turning into the Japanese government bond market — where years of slow growth, zero interest rates, current account surpluses and captive local buyers have depressed borrowing rates for years and turned JGBs into an increasingly domestic market dominated by local banks, pension funds and insurers. Non-residents hold less than 10 percent of JGBs, compared to more than 50 percent for the EGB as a whole, and Japanese banks hold up to 35 percent of their own government bond market.
But is the euro government market heading in that direction after successive crises have seen foreign investors flee many of the peripheral markets of Greece, Portugal, Ireland and even Italy and Spain? Fransolet argues that the seniority of substantial European Central Bank holdings built up in the interim (now about 15 percent of each of the five peripheral markets) may be one reason why these foreign investors will be wary of returning. Meantime, euro zone banks, who have traditionally held a high 20-25 percentage point share of euro government markets, withdrew sharply late last year amid balance sheet repair pressures but have rebuilt holdings again sharply in early 2012 after the ECB’s liquidity injections — particularly in Italy and Spain.
In answer to the longer-term question of whether euro bonds will turn into a more insular market dominated less by interest rate signals than liquidity, regulatory and balance sheet issues, Fransolet is equivocal. On one level they are still very different — state-sector holdings of euro debt are still far from Japan’s, the euro market has clearly fragmented and net new issuance of euro debt is also still way below Japan.
However, the trend is clearly toward a more domestically driven market in the periphery of euro bloc in particular and local banks are becoming bigger players. And, crucially, although foreign investors may not return en masse soon, their impact on those markets via futures and CDS markets and index weightings may still be high.
Financial repression revisited
At a monetary policy event hosted by Fathom Consulting at the Reuters London office today, former Bank of England policymakers were discussing the pros and cons of “financial repression”.
Financial repression is a concept first introduced in the 1970s in the United States and is becoming a talking point again after the financial crisis, especially with a NBER paper last year written by economists Reinhart and Sbrancia reviving the debate.
In the paper, authors define financial repression as follows:
Historically, periods of high indebtedness have been associated with a rising incidence of default or restructuring of public and private debts. A subtle type of debt restructuring takes the form of “financial repression”.
Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks.
Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real
Teflon Treasuries?
The pleasant surprise of Friday’s upbeat U.S. employment report rattled the U.S. Treasury bond market, as you’d expect, encouraging as it did some optimism about a sustained U.S. economic recovery, tempering fears of deflation and casting some doubts on the likelihood of another bout of quantitative easing or bond buying by the Federal Reserve. And investors wary of seemingly teflon Treasuries are always keen to use such a backup in U.S. borrowing rates as a reason to rethink a market where supply is soaring and national debt levels are accelerating and where the country has just entered a presidential election year.
The release then by Eurostat on Monday of 2011 government debt levels for the European Union and euro zone — where bond markets have been in chaos for the past couple of years — provided another reason to look sceptically at Treasuries as it showed aggregate EU and euro zone debt more than 10 percentage points of GDP lower than in the United States.
And with no fresh debt reduction plan likely this side of November’s presidential elections, the comparative U.S. debt trajectory over the coming years looks alarming.
Strategists at Societe Generale map the two for effect.
Sparring with Central Banks
Just one look at the whoosh higher in global markets in January and you’d be forgiven smug faith in the hoary old market adage of “Don’t fight the Fed” — or to update the phrase less pithily for the modern, globalised marketplace: “Don’t fight the world’s central banks”. (or “Don’t Battle the Banks”, maybe?)
In tandem with this month’s Federal Reserve forecast of near-zero U.S. official interest rates for the next two years, the European Central Bank provided its banking sector nearly half a trillion euros of cheap 3-year loans in late December (and may do almost as much again on Feb 29). Add to that ongoing bouts of money printing by the Bank of England, Swiss National Bank, Bank of Japan and more than 40 expected acts of monetary easing by central banks around the world in the first half of this year and that’s a lot of additional central bank support behind the market rebound. So is betting against this firepower a mug’s game? Well, some investors caution against the chance that the Banks are firing duds.
According to giant bond fund manager Pimco, the post-credit crisis process of household, corporate and sovereign deleveraging is so intense and loaded with risk that central banks may just be keeping up with events and even then are doing so at very different speeds. What’s more the solution to the problem is not a monetary one anyway and all they can do is ease the pain.
Low interest rates and liquidity schemes can’t solve what ails the developed world. Societies must accept that in order to alter their current perilous course they must undergo great change, moving away from entitlements to which they have become accustomed. The alternative is weak economic growth, a loss of competitiveness and negative external balances — a loss of face and place in the global hierarchy.
As if to reinforce the underlying point that the developed world faces a protracted reform period that tests political, economic and social priorities, credit rating firm Standard & Poors’ — not the most popular company in corridors of power over the past year — warned on Tuesday that it may downgrade the debt of “a number of highly-rated” Group of 20 countries from 2015 if their governments fail to enact reforms to curb rising healthcare spending and other costs related to ageing populations.
For Pimco, the political and social resistance to this sort of change is already showing itself to be significant both in Europe and the United States. People clearly don’t want to see pensions and benefits cut but politicians have already grown government and sovereign indebtedness close to their maximum. Accommodative central banks that helped them get there only ended up fueling credit, consumption and housing bubbles and distorting the balance of the economy away from production and into an increasingly bloated financial sector. That, clearly, ended in tears as finance itself needed bailing out and compounded the sovereign debt burden.
So if harder, longer-term choices and reforms are now needed, central banks ability to continually reflate the world economy by monetary means alone is at best uncertain, Pimco argues. The risk of major upheavals along the way in Europe, for example, has the potential for major market volatility and economic seizures.
Renihart is exactly right. But there is a darker theory yet: that Fed policy is just part of a government-wide strategy of practicing “financial repression” to escape from the consequences of the debt explosion. The leading expert on financial repression is Carmen Reinhart of the Peterson Institute. She defines it as a situation in which “governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere.”
Low or negative real interest rates are among the oldest examples. Call this monetary repression. Reinhart points out that it was practiced on a large scale by governments after World War II. She asserts that it accomplished by stealth the effective cancelation of government debt without resort to orthodox spending and tax policies for which governments knew then and now that they cannot get the electorate’s consent.
A similar debt predicament today implies that monetary and other forms of repression are again on the cards, especially in the United States. Wainwright has attempted to measure it, but estimates of real interest rates and monetary repression are fuzzy and contentious, especially because the government as¬serts control over the method by which inflation is measured.
Nevertheless, the company’s research, estimates that the Fed’s interest-rate policy in 2007-11 has cut the real interest rate from a normal 2 or 3 percent to an aver¬age of minus 7 or 8 percent. That’s a diversion of about ten percentage points a year to the Treasury and other borrowers—just about enough to fund the current budget deficit. Genius…
Luis de Agustin