Quick Overview

Looks like something positive is brewing in Europe, but I don’t want to jump the gun. China looks weak, US probably through its worst, Europe still faces plenty of pain even if fiscal reform and euro-bonds introduced. Game changer would be QE/asset purchases by Fed and ECB.

The scourge of government debt – macrobusiness.com.au

A report on a talk by Yanis Varoufakis, author of The Global Minotaur, gives some nice history of how we got here. The Minotaur is a marvelous metaphor for what governments have allowed to occur in the global financial system. Now they, and all of us, are being skewered by its horns:

“In the immediate post-war era, Varoufakis claims, “the Americans begin to take seriously the redemptive mission to save capitalism from itself.”

But in doing so, against its apocalyptic competition with the Soviet Union, America spread itself too thin. Or too thick. By the time it was funding LBJ’s Great Society reform programme, alongside the dire weight of the Vietnam war effort, America stopped being a surplus nation. It went into deficit.

What followed was a worldwide project to balance everyone else’s books in line with the Americans own – what Paul Volcker, American economist and head of the Federal Reserve from 1979-1987, called the “controlled disintegration of the world economy”…..

Towards the end of his speech, Varoufakis claimed: “The Left and Right miss the significance of this current juncture. It is not terminal for capitalism, but it has ended the conglomeration of illusions in how we viewed the world. It ended the illusion we had that we had something called free market capitalism.”

via The scourge of government debt – macrobusiness.com.au | macrobusiness.com.au.

The Weekend Interview with Peter Brabeck-Letmathe: Can the World Still Feed Itself? – WSJ.com

Recent decades have seen “the creation of more than a billion new consumers in the world who have had the opportunity to move from extreme poverty into what we would call today a moderate middle class,” thanks to economic growth in places like China and India. This means a billion people who have “access to meat” for the first time, Mr. Brabeck-Letmathe [Chairman of Nestle] says.

“And the demand for meat,” he says, “has a multiplier effect of 10. You need 10 times as much land, 10 times as much [feed], 10 times as much water to produce one calorie of meat as you do to have one calorie of vegetables or grain.”

via The Weekend Interview with Peter Brabeck-Letmathe: Can the World Still Feed Itself? – WSJ.com.

Polish Economy Defies Europe’s Woes – WSJ.com

Poland’s economy expanded robustly in the second quarter despite slowing growth in the euro zone, outpacing Central European peers more dependent on exports to Germany.

……Much of the strength in Poland’s domestic demand was the result of government spending on infrastructure, supported with European Union subsidies, which more than offset a slight slowdown in the rate of growth in private consumption.

via Polish Economy Defies Europe’s Woes – WSJ.com.

The way forward

There were plenty of central bankers and economists with glum faces at Jackson Hole, Wyoming this week as speakers reviewed the challenges ahead. So far the global economy has not responded to various rescue plans, with GDP slowing and national debt rising across a whole slew of economies.

Before we look at the daunting challenges ahead,we should review what has already been achieved. We avoided a global banking collapse, an accompanying deflationary spiral and a depression similar to the 1930s. There have been a few side-effects, but do not underestimate the importance of avoiding a deflationary spiral.

Deflationary Spiral

In times of uncertainty, households and corporates save at higher than normal rates. Savings contribute to economic growth when channeled through the financial system into new investment, but in a financial crisis they are applied to pay down debt, causing a savings-investment mismatch. Any amount saved that is not re-invested in the economy, whether it used to pay down debt or buried in a tin at the bottom of the garden, causes a fall in national income.

If 2% of every trillion dollars earned, for example, is used to repay debt, then people who would have supplied 1 trillion dollars worth of goods and services will only receive $980 billion in income. That doesn’t seem so bad, but if 2% of the reduced income is similarly applied to repay debt, then income available contracts to $960.4 billion. And keeps contracting each time income is recycled. In extreme cases the above scenario could be replayed many times over before the behavior ends, causing a sharp fall in national income. Repetition of the above cycle twenty times, for example, would reduce available income by a third. That is a deflationary spiral. Something to be avoided at all costs.


The proven antidote to deflation is to run a fiscal deficit: government expenditure in excess of revenue helps to offset the savings-investment shortfall. Stimulus programs, however, have been badly managed, with no thought as to how the burgeoning national debt would be repaid. Mountains of national debt were incurred to head off the deflationary spiral, but there is very little to show for it. Deficits spent on school halls, public fountains, checks in the mail and tax cuts offer no means of repayment. Investment in infrastructure projects that offer a market-related return on investment — that can be used to repay the debt over time — have so far been scarce.

The result of a weak fiscal balance sheet is instability. High unemployment, low consumer spending, restricted consumer credit, and a falling housing market are all consequences of increased uncertainty.

Also, private capital investment remains scarce despite super-low interest rates and cashed up corporate balance sheets. For the same reason that cashed up banks are not lending to small business: uncertainty. Both banks and business face an unpredictable environment, with the possibility of further falls in employment and consumer spending, restricted consumer credit, a falling housing market, unsustainably low interest rates, and the threat of increased taxes. Uncertainty equals risk, and any CEO worth his/her salt would scale back on expansion plans until they have a clearer picture of what the future holds.

Unemployment will remain high and GDP growth low until capital investment is restored. The problem is: how?

Possible solutions

The answer may sound simplistic, but we need to reduce uncertainty to provide business with a stable foundation on which to plan future investment. There are four possible solutions, but none of them are pretty.

The first is austerity: cutting government expenditure to match revenues. Austerity is important but on its own is likely to deliver even lower growth than at present — and risks a deflationary spiral. Cutting government expenditure while private savings are being used to pay down debt, without an equivalent cut in tax revenues, would court disaster.

Raising taxes is another popular option: getting everyone to pay their fair share. Though the notion of fair share varies widely depending on who the speaker is — and who pays their campaign contributions. Revising the tax code to achieve a more equitable distribution of the tax burden may contribute to long-term stability — a fair tax system is more likely to stand the test of time — but increasing tax revenues to repay national debt would also risk a deflationary spiral.

A third solution is massive public works programs similar to those undertaken by China during the GFC. Infrastructure projects directly stimulate local business and increase employment while also delivering savings in unemployment benefits. Government infrastructure investment, however, has a checkered history. Cost overruns and failure to meet revenue projections make private sector funding difficult to obtain. And government funding would further increase the national debt.

The fourth option, a soft default on existing debt, through inflation, is obviously tempting. Debasing the currency by selling Treasurys directly to the Fed, for example, would:

  • Reduce national debt in real terms;
  • Create a surge in investment demand for real assets as a protection against inflation — lifting stock prices and the housing market;
  • Bail out the banks, who are threatened by shrinking housing prices; and
  • Give currency manipulators a sizable haircut on their existing Treasury investments and discourage further “pegging” against the dollar. China and Japan collectively hold more than $2 trillion in US Treasurys (Washington Post), accumulated to suppress appreciation of their currencies against the greenback and create a trade advantage.

An unwelcome result, however, would be a massive spike in inflation. At some point the Fed would have to raise interest rates sharply, effectively slamming the economy into reverse, in order to cure inflationary expectations. So we could defer the recession for now, in the hope that the economy is on a sounder footing when it re-visits us later.

The way forward

While each of the options has their downside, a combination of the first three seems to offer the best solution. Funding infrastructure investment through a combination of private sector funding, austerity cuts and increased taxes could avoid the  risk of a deflationary spiral, with minimal increase in the national debt. It would also facilitate direct channeling of private savings into investment, reduce wasteful government expenditure (through an austerity drive) and could be used to justify a more equitable distribution of the tax burden (if we all benefit we should all expect to pay).

The fourth option, a soft default through inflation, should be seen as a last resort. And is probably why QE3 was not put forward at Jackson Hole last week. Once you awaken the (inflation) dragon, he can prove difficult to slay.

What we need and what we actually get may be vastly different

This is in response to a question raised by Thomas Franklin:

Hi Colin,

….. My question is not just about the bond market although it is part of it but a reflection of the bigger picture globally with what is unfolding. With many governments facing rising debt levels and the Feds policy of financial stimulus, surely this is just delaying the inevitable of “Global Financial Meltdown” The USA and the dollar is a sinking ship, with the Fed losing the battle of bailing the ship out. So what do you think will replace the system we currently have?

Hi Thomas,
What we need and what we actually get may be vastly different.
Firstly, what we need:

  • A consensus Swiss-style democracy instead of the winner-takes-all system we have at present, where incumbent politicians run up fiscal debt in order to boost their chances of re-election.
  • Restrict the Fed to a single mandate, to protect the currency, rather than targeting inflation to help the politicians.
  • Restrict capital flows between countries, like China/Japan’s purchase of >$2 trillion of US Treasurys, used to manipulate exchange rates and create a massive advantage for their export industries.
  • Austerity to cut unnecessary spending and public works programs to improve national infrastructure and create employment — but the programs must deliver real returns on investment so they can later be sold off to repay debt.
  • Europe needs a eurobond system, with central borrowing and restrictions on individual member deficits.

What we will probably get is:

  • More of the same: government controlled by special interests and dominated by fear of the next election.
  • The Fed going nuclear and buying more Treasurys — creating inflation to bail out the banks and save Treasury from default.
  • Inflation as a soft form of default to give bondholders (read China/Japan) a haircut and deter them from buying more Treasurys.
  • More profligate spending and ill-chosen, bridge-to-nowhere infrastructure projects.
  • A breakup of the Euro?

Hope that doesn’t sound to optimistic 🙂

Regards, Colin

Innovate or die – macrobusiness.com.au

Spence says it has not yet been fully recognised that the economic malaise is not just a cyclical downturn caused by excess debt, over-consumption, low interest rates and lax regulation, but part of a long-term structural change brought about by globalisation and technology, which are shifting the comparative advantage in a range of industries and services towards the developing world.

Europe, the US and other advanced economies must make long-term reforms to labour markets and boost productivity as well as encourage public and private sector investment in infrastructure, education, skills and training to remove growth constraints. Short-term fixes, such as Europe’s bailout packages and the US Federal Reserve’s promises of low interest rates for longer, can do little more than “kick the can down the road”, he says.

via Nobel laureate economist Michael Spence| as reported in Innovate or die – macrobusiness.com.au.