Placebo Effects: Part 2

By: Satyajit Das

Withdrawal Method…

Given the size of government intervention, a key question is the timing of withdrawal of support for the economy. Like the eponymous technique of contraception, it will need to be carefully timed.

The current apparent health of the financial system owes everything to wide-ranging government support. The ability of the banks to raise equity and debt is substantially underwritten by the "too-big-to-fail" doctrine. Profitability is supported by low and, in some cases, zero cost of deposits and a sharply upward sloping yield curve that creates significant earnings from borrowing short and lending long. Withdrawal of support may expose deep-seated and unresolved problems in the financial system.

Substantial quantities of structured securities are now held by central banks either as collateral for funding arrangements or through other innovative market support mechanisms. This has substantially increased the size of central bank balance sheets in the U.S., U.K and Europe.

It is not clear how and when these ‘temporary’ positions will be unwound. Attempts to create structures for repackaging these securities, such as the frequently touted but still to be implemented Public Private Investment Partnership ("PPIP") program, have enjoyed limited success. Untimely attempts by governments to liquidate these portfolios may be disruptive to fragile markets.

These securities may have to be held to maturity (sometimes over 10 years in the case of some Asset Backed Securities ("ABS")) and allowed to self liquidate from the underlying cash flows. The bloated central bank balance sheets may restrict policy flexibility significantly.

Government spending has been substituted for private consumption and investment. The deficits will ultimately necessitate a combination of increased taxation and reduced spending to correct this position.

Assume a country has government equal to 100% of its GDP. Assuming an interest rate of 5% p.a. and a GDP growth rate of 4% p.a., a 1% budget surplus is required to maintain debt at current levels. If the gap between interest rates and growth is greater, then the size of the required surplus is commensurately larger. In effect, it is unlikely that the present expansionary fiscal position can be sustained over a long period. The fiscal position of major economies may restrain growth.

Central bankers have tried to sooth markets about the timing and method of withdrawing life support. The cast consists of the same individuals who failed to identify or take actions to prevent the problems arising in the first place. The risk of policy errors cannot be discounted. Untimely or misjudged withdrawal of support may easily result in recovery interruptus.

Fundamental Truths…

Belief in the recovery story and sharp financial market rallies fail to recognise that little has actually changed since the GFC began. Fundamental failures have not been fully addressed.

The required reduction in debt levels has not been completed. Increases in government debt have substantially offset reductions in private sector debt.

Instead of dealing with the problem of leverage, the debt has also merely been rolled forward through a variety of clever warehousing structures and the manipulation of accounting rules.

In a system that has excessive leverage, there are only two adjustment mechanisms. The value of assets supporting the debt and income available to service the borrowing can be increased, usually by inflation. The value of the debt can be reduced through writing it down to the real value of the assets.

Governments and central banks have gambled on inflation despite its social and economic costs. In reality, inflationary pressures in the global economy are not apparent. The rebound in energy and food costs has prevented deflation. The absence of demand, excess capacity, reduced credit creation and low velocity of money circulation may mean that it is dis-inflation or deflation that is the problem going forward.

There is now faith-based reliance on Governments’ ability to rescue the economy. Intervention has helped stabilise economic activity and the financial system but it improbable that government actions alone can prevent the necessary adjustment in debt levels and growth rates.

Government’s share of most developed economies is around 25-40% of GDP. It role in liberal democracies is limited by the fact that is fundamentally an intermediary, not dissimilar to a bank. It derives its resources through taxation from certain sectors of the economy and redirects it to other sectors. This means that its ability to control an economy has limits in the absence of nationalisation of all productive activity.

In the short run, governments can borrow or print money to augment its resources. Like all debt it borrows from tomorrow to pay for today. Quantitative easing (the now respectable name for ‘printing money’) also has limits unless governments are willing to risk hyper-inflation and the social dissolution of the Weimar Republic or Zimbabwe. While governments can influence an economy, they cannot completely reverse inevitable adjustments dictated by market forces.

Governments may also be impeding necessary adjustments. Rising government investment is increasing capacity in a world with stagnant demand and over-capacity in many sectors.

China’s current growth is being driven by government investment that is increasing capacity, which in the absence of sufficient domestic demand may be directed to exports increasing the global supply glut. Politically and socially motivated bailouts of national champions and strategic industries mean the necessary reductions in capacity through bankruptcy and corporate failure have not been allowed to happen.

There are even signs that the financial sector is rediscovering old habits. The government and taxpayer paid for return to profitability of major financial institutions and the return of remuneration levels to pre-crisis levels raises fundamental questions about whether any change has occurred. Despite the egregious excesses, governments seem collectively to lack the will to reform the financial system to avoid the problems of the past.

Actions to stabilise the global economy seem only to have created ‘new’ bubbles – in government debt and emerging markets. Government actions seem to be primarily designed to ensuring continuation of the ponzi game. The only lesson learned is that no ponzi game can ever be allowed to stop.

As one anonymous saying states: "Never in the history of the world has there been a situation so bad that the government can't make it worse."

Global Questions…

There is broad agreement that a key component of the GFC was the problem of global capital imbalances. A central feature was debt funded consumption by the U.S. that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit. Japan, China, Germany and the other savers funded the consumption. At its peak, the U.S. was absorbing about 85% of total global capital flows to fund its government and private debt.

Any lasting solution to the GFC requires this imbalance to be dealt with. The glib solution requires the U.S. to save more and consume less and the savers to save less and consume more. The problems in implementing the solution are considerable.

Timothy Geithner’s recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and U.S. Treasury Bonds, reveals the dilemma. On the one hand, America needs the Chinese to continue and increase their purchase of U.S. Government debt to finance its fiscal stimulus and bailouts. On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings. All this should also occur ideally without any major decline in the value of the dollar or U.S. Treasury bonds or the need for China to liberalise it currency and open its capital account allowing internationalisation of the Renminbi!

A cursory look at the respective economies highlights the magnitude of the task. Consumption’s contribution to GDP in the U.S. is 71% while in China it is 37%. Given that the GDP of China is around $4-5 trillion versus $15 trillion for the U.S. and average income in China is around 10-15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.

Additionally, over the last 25 years, Chinese consumption has declined from around 50% to it current levels of 37%. During that same period, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American buyer, lower U.S. growth and declining consumption creates significant challenges for China.

Dealing with these global imbalances has not been a high priority in the various summits, symposiums and talkfests that global leaders have shuttled to and from. The focus has been ‘NATO’ – no action talk only. Half-hearted and unworkable proposals, such as the use of the S.D.R as reserve currency, have emerged.

Reliance on Chinese foreign currency reserves is probably misplaced. Chinese reserves, a large proportion denominated in dollars, may have limited value. They cannot be effectively liquidated or mobilised without massive losses. Increasingly strident Chinese rhetoric about the safety of their dollar assets reflects ‘panic’. The Middle Kingdom finds itself in a ‘running dog capitalist’ trap from which it probably cannot extricate itself easily. The intractable nature of this problem is evident in the frequently contradictory statements from various Chinese spokesman regarding the official position on the dollar.

In reality, China is trying desperately to switch its reserves into real assets – commodity or resource producers where foreign countries will allow. In the meantime, China continues to purchase more dollars and U.S. Treasury bond to preserve the value of existing holdings in a surreal logic. On the other side, the U.S. continues to seek to preserve the status of the dollar as the sole reserve currency (backed no longer by gold but by the 86^th Airborne Division) in order to enable itself to finance itself.

In July 2009, at the G8 Summit in the earthquake damaged town of L'Aquila in Italy, Dai Bingguo, Chinese state councillor, was openly critical of the dominant role of the U.S. dollar as a global reserve currency: "We should have a better system for reserve currency issuance and regulation, so that we can maintain relative stability of major reserve currencies exchange rates and promote a diversified and rational international reserve currency system,"

Western leaders expressed concerns about even raising the issue fearing that discussion of long-term currency issues could undermine the recovery in markets and economies. Gordon Brown, Britain's prime minister, spoke on behalf of the West: "We don't want to give the impression that big change is around the corner and the present arrangements will be destabilised."

No sustainable global recovery is likely without addressing the fundamental global imbalances that lie at the heart of the GFC.

Placebo Effects…

On 14 June 2009, Wolfgang Münchau writing in the Financial Times ("Optimism is not enough for a global recovery") eloquently summed up developments: "Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world."

The placebo effect is a pervasive phenomenon in medicine. A sham medical intervention may cause the patient to believe that the treatment will change his or her condition sometime causing the actual condition to improve. Conditioning, expectations and motivation all can play a role in placebo effect.

In recent times, investors, markets and governments have all come to believe in the ‘recovery’ sometimes by selective interpretation of facts to support the conclusion that they need. Given reluctance or inability to deal with the real problems, it is not entirely clear whether the GFC cures are real or inert treatments. It is also not clear whether current improvements in market and economic conditions are sustainable or merely a short-term placebo effect.

 

© 2009 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

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