While 2012 has started afresh, the lingering problems that started in 2008 still linger over economies and stock markets, writes David Rhodes and Daniel Stelter of Boston Consulting.
The economic travails of much of the West are reaching a decisive stage as the new year begins.
In 2008, we predicted sluggish recovery and a long period of low growth for the West in a two-speed world. This picture does not now properly reflect the downside risks. The policy of "kicking the can down the road" is failing, as the intensifying crisis in the Eurozone and the failure of the G20 summit in late October clearly demonstrate.
Such extreme uncertainty is challenging for companies trying to prepare their budgets for next year or, more fundamentally, trying to plot their strategic course. It helps to have a clear understanding of what may happen and why it may happen. So before we address the question of which scenarios to expect and how to prepare, let us remind ourselves about the root of the problem: the West is drowning in debt.
A World with Too Much Debt
Total debt-to-GDP levels in the 18 core countries of the Organisation for Economic Co-operation and Development (OECD) rose from 160% in 1980 to 321% in 2010. Disaggregated and adjusted for inflation, these numbers mean that the debt of nonfinancial corporations increased by 300%, the debt of governments increased by 425%, and the debt of private households increased by 600%.
But the costs of the West’s aging populations are hidden in the official reporting. If we included the mounting costs of providing for the elderly, the debt level of most governments would be significantly higher.
Add to this sobering picture the fact that the financial system is running at unprecedented leverage levels, and we can draw only one conclusion: the 30-year credit boom has run its course. The debt problem simply has to be addressed.
There are four approaches to dealing with too much debt: saving and paying back, growing faster, debt restructuring, and write-offs, and creating inflation.
Saving and Paying Back
Could the West simply start saving and paying back its debt? If too many debtors pursued this path at the same time, the ensuing reduction in consumption would lead to lower growth, higher unemployment, and correspondingly less income, making it more difficult for other debtors to save and pay back.
This phenomenon, described by Irving Fisher in 1933 in The Debt-Deflation Theory of Great Depressions, can result in a deep and long recession, combined with falling prices (deflation). This is amplified when governments simultaneously pursue austerity policies—such as we see today in many European countries and will see in the US beginning in 2012.
A reduction in government spending by 1% of GDP leads to a reduction in consumption (within two years) of 0.75% and a reduction in economic growth of 0.62%. Saving (or, more correctly, deleveraging) will reduce growth, potentially trigger recession, and drive higher debt-to-GDP ratios—not lower debt levels.
Indeed, during the early years of the Great Depression, President Hoover—convinced that a balanced federal budget was crucial to restoring business confidence—cut government spending and raised taxes. In the face of a crashing economy, this only served to reduce consumer demand.
For the private sector and government to reduce debt simultaneously would require running a trade surplus. So long as surplus countries (China, Japan, and Germany) pursue export-led growth, it will be impossible for debtor countries to deleverage.
As Martin Wolf put it trenchantly in the Financial Times: "The Earth cannot, after all, hope to run current account surpluses with the people of Mars." The lack of international cooperation to rebalance trade flows is a key reason for continued economic difficulties.
Saving and paying back cannot work for 41% of the world economy at the same time. The emerging markets would have to import significantly more, which is unlikely to happen.
|pagebreak|Growing Faster
The best option for improving woeful debt-to-GDP ratios is to grow GDP fast. Historically, this has rarely been achieved, although it can be done—for example, in the UK after the Napoleonic Wars and in Indonesia after the 1997-1998 Asia crisis (although Indonesian debt levels were nowhere near contemporary highs in the West).
Attacking today’s debt mountain would require reforming labor markets or investing more in capital stock. Neither is happening.
Politicians are unwilling to interfere in labor markets given today’s elevated levels of unemployment. Moreover, empirical evidence shows that the initial impact of such reforms is negative, as job insecurity breeds lower consumption.
Companies can afford to invest significantly more, as they are highly profitable. The share of US corporate profits in relation to US GDP is at an all-time high of 13% (as are cash holdings), yet corporate real net investment (that is, investment less depreciation) in capital stock in the third quarter of 2011 was back to 1975 levels.
But companies are reluctant to invest while demand is sluggish, while existing capacities are sufficient, and while the outlook for the world economy remains highly uncertain.
The aging of Western societies will be a further drag on economic growth. By 2020, the workforce in Western Europe will shrink 2.4%, with that of Germany shrinking 4.2%.
Debt in itself makes it more difficult to grow out of debt. Studies by Carmen Reinhardt and Kenneth Rogoff and the Bank for International Settlements show that once government debt reaches 90% of GDP, the real rate of economic growth is reduced. This also applies to the debt of nonfinancial corporations and private households.
In all countries, the debt level of at least one sector is beyond the critical mark. Somewhat perversely, only in Greece are the two private sectors below the threshold. And only in Germany and Italy (in addition to Greece) do private households have a debt level below 70% of GDP.
Assuming a combined sustainable debt level of 180% of GDP for private households, nonfinancial corporations, and governments, we estimated the debt overhang to be 6 trillion for the Eurozone and $11 trillion for the US. We argued that (some) governments might be tempted to fund this through a one-time wealth tax of 20% to 30% on all financial assets.
The target level of 180% can be debated (and was debated by many readers of Back to Mesopotamia), but a level of 220% would still imply a debt restructuring of $4 trillion in the US and €2.6 trillion in the Eurozone, leading to a one-time wealth tax of 12% and 14%, respectively. Given the unpopularity of such a tax, we are likely to see less incendiary taxes imposed. This means that politicians must resort to the last option: inflation.
Inflation
Another option to reduce Western debt loads would be financial repression—a situation in which the nominal interest rate is below the nominal growth rate of the economy for a sustained period of time. After World War II, the US and the UK successfully used inflation to reduce overall debt levels.
In spite of today’s low-interest-rate environment, we have the opposite situation: interest rates are higher than economic growth rates. As risk aversion in financial markets increases and a new recession in 2012 looms large, the problem could get even worse.
So the only way to achieve higher nominal growth will be to generate higher inflation. Aggressive monetary easing has barely moved the inflation needle in the US and most of Europe, although the impact on UK inflation has been greater.
Inflation is not being generated, because the expectation of inflation remains low and because there is still overcapacity and over-indebtedness in the private and public sectors. Continued monetary easing could (and will) lead to a substantial monetary overhang that could, if the public loses trust in money, lead to an inflationary bubble.
|pagebreak|Some argue that inflation is unlikely because of the oversupply of labor and continued competition from new market entrants like China. Certainly we may see continued pressure on wages because of globalization, although the longer low growth persists in the West, the more likely it is that Western governments will resort to increased protectionism, leading to upward pressure on prices. Moreover, some observers believe that the inflation indicators do not give a true reading of the underlying rates of inflation.
It is also a matter of trust. Take, for example, the history of hyperinflation in Germany in the early 1920s. The German Reichsbank funded the government with newly printed money for several years without causing inflation. But once the public lost trust in money, people started to spend it fast. This led to higher demand and an inflationary spiral.
Today, the velocity of money in the US is at an all-time low of 5.7. If the number of times a dollar circulates per year to make purchases returned to the long-term average of 17.7, price levels in the US would rise by 294% over that period—unless the Federal Reserve simultaneously reduced its balance sheet by $1.8 trillion.
Some inflation is probably attractive to those seeking to reduce debt levels. The problem is stopping the inflation genie once it has left the bottle.
There are no easy solutions to the debt problem. At best, we expect a sustained period of low growth in the West. Even this would require the following:
- A coordinated effort to rebalance global trade flows, which would require the emerging markets, Germany, and Japan to import more, thereby allowing the debtor countries to earn the funds necessary to deleverage
- Stabilizing the overstretched financial sector through recapitalization and slow de-risking and deleveraging—in contrast to today’s new rules, which encourage banks to shrink their balance sheets rather than finance commercial activity
- Reducing excessive debt levels, ideally through an orderly restructuring or higher inflation
Current policies fall short against all these criteria. The coordinated intervention of several global central banks on November 30 could be construed as a positive sign of global cooperation, given that the whole world fears the implications of a (disorderly) breakup of the Eurozone.
In reality, it was once again merely a case of pulling the only lever left—that of printing money—and so did not address the one fundamental problem facing the world economy. Even China’s participation reflected its worries about its biggest export market (Europe) and the risk of another (possibly deep) recession more than a true willingness to support the West by rebalancing trade flows.
Any new recession, given growing and unsustainable debt levels, would increase the risk of short-term defaults and significantly increase the medium-term risk of higher inflation. Companies should therefore prepare for these scenarios. But they also need to consider how the situation in Europe could amplify the problem.
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