Part 3
08.03.2010
From credit derivatives bubble to public debt bubble.
The activist government and central bank policies led to the biggest fiscal deficit in the United States on record, EU public debt will top 80 percent of GDP in 2010. Ageing of western societies will likely push up the levels of public debt even further. What actions should be taken by governments in developed world to escape from this debt trap? The answer is inflation, or is it innovation?
What should be done to make sure that crises of this scope do not happen again? Many commentators argue that the present crisis represents a failure of regulators, which either created mechanisms for rapid leverage growth, or failed to step in early enough. What changes in the global regulatory framework are needed to limit the likelihood of "black swans" in future?
Mr. Edmund Phelps reminded us that he was outspoken in his criticism of George Bush in 2002 and 2003, when the last one embarked on massive fiscal stimulus as, according to the economist, that was the expansion of a public debt. At the time when the fiscal position of the government was already vastly short of being able to cover future entitlement pledges made by the government, he was referring to medical security, social security, retirement, and the entitlements in the US. The US needs to be running fiscal surpluses in this decade in preparation for meeting those things, and instead, the Bush administration did the opposite. But just because the government is running a huge deficit, it’s no reason for asset prices to go crazy. There needs to be an understanding in markets that there is no magic in the market - the prices that exist are based typically on faulty analysis. And people should be very cautious. When the government increases anybody’s disposal incomes, as it would be inevitable that there will be some rises in the price of houses, it shouldn’t have been a take-off such as it could have been seen. So there is some room for borrowing in the world without causing a catastrophe, but of course, if markets are unsophisticated then such fiscal experiments run the risk of causing a collapse. To come to the question of policy reform and what to do now, it seems that with a little bit of luck and with a little bit of courage, maybe more courage than the Central Bankers have, it will be possible to call back some of the excess equity that is now in the hands of the private sector and that was created in order to try to cushion the downturn. In theory, it should be possible to call that back without any major inflation arising. On the other hand, Mr. Phelps cannot agree with Ben Bernackie and Martin Wolf of the Financial Times when they say, “You don’t have to worry about that 2 or 3 trillion dollars or what quitted-out there right now. If comes the time when anybody in economy wants to do some investing for business purposes, the FED can leap in and remove the excess equity. So it’s nothing to worry about there”. That analysis seems to be questionable because, after all, if there is a tender box of excess equity in economy that could be one of things that will precipitate in a new wave of investments. So then, it will be too late. Investments, inflation will already have been going down. Prices will already be rising. There will be concerns about future inflation and the dollar. We have to be concerned and try hard to reinstall a sense of fiscal responsibility. In the book from the 1960s entitled “Fiscal neutrality” by Phelps, he makes the point that looking out there is only giving a path of economy, there is a certain amount of government revenue, there is always a certain volume of taxes that have to be collected and when the government introduces a tax cut that doesn’t really make people wealthier than they were before, houses will not be more valuable that they were before. People are making a mistake if they think that tax cuts and the decline of consequences in their disposable income today has made them wealthier. Because later, they all have to see tax increase, higher than otherwise would have been in order to meet the fiscal constraints. Now the public is even more remote from that way of thinking. There is simply no forward-looking quality to discussions of a tax policy and discussions of revenue requirements as if the legislators in Washington want to put their heads in the sands like ostriches. And pretend that this tremendous fiscal overhang coming due in 2020 in the entitlements of medical care and social security are not there. And now of course we have all this additional depression borrowing which is piling on more debt. That is why Mr. Phelps is of the opinion that the American economy will survive at the level of 70% GDP. It had that much or more in the late 1940s and early 1950s. But it’s very important that very soon we restore the sort of understanding that will lead to return of fiscal responsibility.
According to Mr. Schiff, there is no best exit policy for the market. “The FED has no exit policy – that’s all a bluff” – he says. “The FED is just saying what the market wants to hear. If they told the truth, everybody would panic – so they lie”. The US has borrowed more money that it can ever possibly be able to repay. And the only way this money can be repaid is to borrow some more. The US government issues a treasury debt and when it matures, more money is borrowed to pay it off. Also, the money is borrowed to pay the interests. The minute the music stops no new borrowers will be found. It’s over. If you borrow money to produce, you can generally pay it back. Usually a business borrows money, to build a factory, to make an investment - there are productive assets here, there is a way of repaying the debt because you have income producing assets to do it. But when you borrow to consume – you don’t have anything – the money is gone! You can’t pay it back! And that’s what the US has done. Referring to Mr. Phelps, who said that that the US have had high debt to GDP levels in the past, Peter Schiff retorted that back then there was a much different GDP. America was manufacturing, making stuff. Right now American GDP is a bunch of fluff as it’s all spending borrowed money. So it’s a very different story. Mr Schiff predicts that the US is going to find out is that the same mistakes have been made as mortgage borrowers did. One of the reason that the housing bubble got so big was because a lot of people relied on adjust rate mortgages (you are able to borrow money for 30 years but you have a teaser rate for the first few years where your mortgage payment is a lot lower). And then, all of the sudden, it jumps up. But what a lot of Americans did, they took that teaser rates and they maxed out. They bought the biggest homes they could afford based on a teaser rate. They didn’t care what was going to happen to the interest rates, what to do with the mortgage payments when the interest rates reset because they were going to be rich. They were buying houses. And they didn’t care. They got the temporary benefit of a loan mortgage payment but with a trade-off being the risk that the payment will go up. The US government is doing the same mistake. There is a national debt now upwards of 10 trillion dollars. And that’s just the funded debt. But if you take the funded debt, which of course does not count, the debt that is now guaranteed from entities like Freddy or Fannie is now the equivalent of a treasury debt. And we are financing at a short-end. We’ve got the biggest adjust mortgage in the history of mankind. And what’s going happen when short–term interests rise, as they inevitably will? What’s going to happen when the US has an annual interest payment of 2- or 3 trillion dollars to its foreign creditors on the national debt? There is no possibility of paying. There is no way to tax the citizens to pay that bill. There is only one thing to do – print money. But printing money to pay back debts is the same thing as the default. One needs to remember that even though the creditors get their money, the money doesn’t have any value, namely no purchasing power. That is why the nature of the debt needs to be understood and the US has to come up with some type of restructuring. It will be much more honest, to come clean with the world and admit that there is no possibility of paying and therefore some solutions have to be worked out to restructure the debt to avoid the inflationary scenario. Also, the US has to move away from the concept of the government insuring or guaranteed the debt. There is too much borrowing in the US instead of the market. Lenders must stop thinking about the government guarantees. They have to be nervous and scrutinize their loans. Only when they are worried do they do a better job of checking into the crediting of borrowers, and then they charge more realistic interest rates. They require better collateral. All those things happen when there are market forces at work. But when a government interferes in the market, there is no efficient allocation of capital and credit. Today situation shows that entities are too big to fail. The only reason they are too big to fail is that the government made them too big to fail. Otherwise the market would prevent this. And now the problem is that these entities that are now too big to fail are able to borrow all sorts of money, whereas smaller companies that might have a sound balance sheet, that might be better to credit work risks, might get priced out because they are not too big to fail. It is a distortion. Now, when the government comes into the market to allocate credits to some place it takes it away from some place else. People have to understand that the government has no resources. The government has no wealth. It produces nothing. If the government is going to give somebody money ,he will take it from somebody else! If the government is going to direct saving to one company or individual, it’s depriving somebody else’s savings. As a result, a less efficient allocation of resources is gotten. Markets allocate resources efficiently. You have a profit motive, you have incentives. And businesses have a profit incentive and they organize resources to satisfy the demands of consumers. People who are doing it successfully are rewarded with profits. The ones that do it unsuccessfully have losses. One cannot run losses in perpetuity. Unless you are the government! Once you get the government involved you have the government propping the business. The US government now owns General Motors and Chrysler. These companies will never make a profit! Now they are like the post office. But they will exist in perpetuity not for the benefit of consumers or shareholders but for the benefit of government constituents, the labour unions, the executives of these companies who are now high-paid government employees. And they can continue to make cars that nobody wants to drive, until the government is broke. Because there is no market mechanism. Had the government simply allowed a lot of these companies to fail, the market would be corrected with these mistakes and credits would be flowing to be more productively used. If the Federal Reserve wasn’t buying credit card debt and mortgage debt and other loans that turned it over into trillion dollars, a lot of this reckless consumer spending would have already come to an end. The only reason that it hasn’t is because the Federal Reserve is still subsidizing it. And those government subsidies had to stop. That is the root-cause of our problem.
What will happen to the dollar when markets realize they will get back only 80 cents on the dollar invested in the US government debt? Will it be a default or inflation?
Mr. Schiff answers that it’s a lot better if the US government would have restructured and the restructuring is more important than the actual debt. There is a need to reform everything. Getting 80 cents on the dollar, 70 cents on the dollar while the dollar maintains its purchasing power is better that being paid in full in Monopoly money (which is ultimately what is going to happen). Even if the dollar doesn’t become completely worthless, it’s going to be worth a lot less than it’s worth today, so nobody who is taking Euros or any different currency to buy the US treasure – no one is going get their Euros back, it is not even possible. If one gets 50 eurocents at most, he should consider himself lucky. Restructuring will be better, but politicians are not likely to do that as they don’t like to admit their mistakes. They want to pretend that there is no problem, that we can keep on borrowing as long as we print money and pay it back.
Clement’s view on the European exit policy and regulation that Europe should adopt to be a winner in this after–crisis world. Clement emphasizes that an effective regulation of the global financial market we have learnt so far have failed: the supervision, the rating system, the political control. And it is time to change it. Both the banks and the bankers have to learn that they should serve the economy, not to dominate it. Secondly, the policy of excessive indebtedness must be finished. In Europe it is the task of the EU Commission to care for. In Germany in the last weeks there were some changes into the constitution to reach this aim so that the instruments will work from 2013. The aim is that in normal times, outside economic crisis, the public hands in Germany has to act without credits and this aim they want to reach by 2020. Reaching it acquires also changes in the social system. And it should happen all over the Western Europe and in parts of the Eastern Europe because of the deep demographic change in the European countries. Of course, it happens in most countries but our problem is Europe. In Germany there is a birth rate of 1,36 children per woman and also increase in life expectancy. The life expectancy is growing in the whole Europe, whereas the current social systems were developed in times of our parents. And this is a very complicated political task. Now the problem is how to solve the problem of the financial crisis. But also we cannot forget that there are the ageing system to reform, the pension system, health care system, a long-term care system that need changes. Abandonment of these will lead to the growth of costs by 2060 by 5% in all Western European states, in Poland about 4%. Moreover, instead of investing more in our social system, pension system, health care system that are too expensive, the change must give the chances to the young generations. Taking into consideration the fact that 10% of pupils don’t reach the end of a school and that the youngsters between 20-25% leave school without any preparation for the job, every talent in ageing societies counts. This must be changed and that means we must invest in, instead of our social system, in kindergartens, schools, universities, life-long learning. This is the answer. This means the fight against unemployment. And reaching this aim to fight successfully against unemployment means to take care of the public debt and to make the turnaround in our countries especially policies. This is what has to be done. And in Germany, after the election of this month, the discussion will start. And it will start everywhere in Europe. All the problems are similar as it is in Germany and they will be successful.
Mr. Bailly also pointed out the three pillars of innovation:
1) energy supply, energy security, including green energy;
2) health care, making sure to treat an ageing population;
3) modernization as there is a poverty gap increasing in the world.
When talking about healthcare we expect that life expectancy of today born children may reach up to 100 years. In order to face this problem, innovations and technology are the solution there so the change of the paradigm of healthcare is necessary. Today people wait until symptoms occur and at the late stage they are being treated. Reversing the paradigm means that preventive and predictive medicine should be at the very beginning. Today technology may help us and our investments should be directed towards those 3 pillars: energy, healthcare and modernization. Mr Bailly’s company is investing 6 billion every year just for modernization and 1.4 only is going for green technologies. So working on innovation is maybe an answer to providing jobs and a certain way of putting the productivity, which is needed to avoid this massive inflation, which is a big risk.
Mr. Rostowski came back to Wolfgang Clement’s speech that the system of regulation failed and we need to reconstruct it. Mr. Rostowski is of a belief that there is neither a system of regulation that will protect us from the consequences of macroeconomics nor from every single minor slow- down. When we remove all of the fear from the greed and fear equation in the financial sector it proves that there is no regulation that could protect us. The fundamental problem that we have is that famous Greenspan put the famous promise, implicit in the policy of Federal Reserve that nothing really bad would ever happen. The result of that mistake is now being compounded. Have been made a massive mistake on the monetary policy side, a massive mistake particularly in the Anglo-Saxon World, in the US, Great Britain, Ireland, on the fiscal policy side. And public debts that are clearly unsustainable are being built up. In Poland, there was a refusal to take the easy path of actively increasing debt. And at the beginning of the crisis, instead of launching discretionary programs of expenditure, discretionary expenditure was cut back by 1% of GDP. It is the only country in Europe that’s done that without having to. As a result, Poland is the only country in the EU, which is going to pass through this crisis without the recession as well as it’s the country which is probably going to have the best growth record in the OECD!! And that is not unrelated to the refusal to make that kind of mistakes that had been made above all in the US and the UK. But allowing so-called automatic stabilizers to function means that there is much bigger deficit than Poland would like. As it happens with many things, restraint and common sense and having to face really hard decisions of making the fiscal account balance over the medium term is certainly going to be easier to do it if one hasn’t made the huge mistakes of running to over a dozen percentage of GDP that have been made in the Anglo-Saxon countries.
Prof. Rybiński’s summary
Forecasting future is difficult. You’ve heard five great insights into a future which is more certain than ever. I hope it will help you in making better decisions about investments and, portfolios. Let’s just hope that the exit strategies that are aimed today are good. We don’t call for bigger market corrections in the next few years, when the time comes to pay this debt of mountain.
