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Monday, March 30, 2009


g20 prospects poor

alan kohler of australia's business spectator analyzes the leaked draft statement to emerge from the g20 summit in london this week.

[T]he G20 diplomats have been working for weeks to draft a communiqué that is sufficiently short on detail for their bosses to safely sign.

It was published in the Financial Times last night, with a few blanks in the IMF section for the sums to be inserted, and brackets around their aspirations for the impact of the fiscal expansions produced so far on world growth (2 per cent increase in output) and employment (20 million jobs).

as one might have expected, short of this statement being scrapped the summit will be a massive failure for those expecting some real action. and that is a problem in the eyes of some, including george soros.

The forthcoming Group of 20 meeting is a make-or-break event. Unless it comes up with practical measures to support the less developed countries, which are even more vulnerable than the developed ones, markets are going to suffer another sinking spell just as they did last month when Tim Geithner, Treasury secretary, failed to produce practical measures to recapitalise the US banking system.

... Among other measures, both Europe and the US in effect guaranteed that no other important financial institution would be allowed to fail. ...

... As a result, capital fled from the periphery to the centre. The flight was abetted by national financial authorities at the centre who encouraged banks to repatriate their capital. In the periphery countries, currencies fell, interest rates rose and credit default swap rates soared. When history is written, it will be recorded that – in contrast to the Great Depression – protectionism first prevailed in finance rather than trade.

Institutions such as the International Monetary Fund face a novel task: to protect the periphery countries from a storm created in the developed world. ... [N]ow they must deal with the collapse of the private sector. If they fail to do so, the periphery economies will suffer even more than those at the centre ....

Yet profound attitudinal differences have surfaced, particularly between the US and Germany. The US has recognised that the collapse of credit in the private sector can be reversed only by using the credit of the state to the full. Germany, traumatised by the memory of hyperinflation in the 1920s, is reluctant to sow the seeds of future inflation by incurring too much debt. Both positions are firmly held. The controversy threatens to disrupt the meeting.

soros advocates the use of IMF special drawing rights (SDRs), lent from the center to the periphery, to finance the periphery through the crisis. if there is no consensus for doing so, soros fears that periphery collapses will quickly jeopardize the world economy. and this is very possible, given what is already happening.

the ft's wolfgang munchau elaborates on the slide in developed economies and therefore their banking systems, which is massive even without presumptions of an eastern european collapse.

Economists and policymakers who wonder how much it will take to recapitalise the banking sector are discovering that rescuing the banks is a much more dynamic exercise than they thought. Whatever you think it costs – and there have been widely different estimates – it is likely to end up costing you a lot more for that precise reason. The economy is trapped in a vicious circle where credit crunch and recession mutually reinforce each other.

ed harrison of credit writedowns reinforces that point highlighting the imminent difficulties of major western european lenders.

munchau's point is that policy efforts to date are simply insufficient, and by a wide margin. he hasn't any of the hope that soros might for the g20. ambrose evans-pritcahrd is likewise hammering on the need of a new consensus in london.

Do not be misled by apparent normality. Unemployment lags, and social devastation lags further – although it has already hit the Baltics and Ukraine. Do not compress the historical time sequence either. Life seemed normal in early 1931 when the press reported "green shoots" everywhere. Part Two of the Depression was the killer. Part Two is what we risk now if we botch it.

Yes, we have done better this time. We saved the credit system. Central banks have slashed rates to near zero in half the world economy. The heroic Bank of England has pioneered monetary stimulus a l'outrance, even if the ungrateful wretches of this island mock their own salvation. But we must move faster because world manufacturing is collapsing at three times the speed. The damage that occurred from late 1929 to early 1931 has been packed into six months. Japan's exports fell 49 per cent in January. Holland's CPB Institute says global trade shrank 41 per cent (annualised) from November to January. Industrial output has fallen heavily over the last year: by 31 per cent in Japan, 24 per cent in Spain, 19 per cent in Germany, 17 per cent in Brazil, 13 per cent in Russia and by 11 per cent in the UK and US. Almost all has occurred since September.

In any case, the European Central Bank (ECB) is still standing pat. It is partial to medieval leech-cures – and hamstrung by the lack of EU debt union. Now, if the G20 were to convey the world's wrath at Europe's monetary paralysis, we might get somewhere. But Gordon Brown has been sidetracked by fiscal flammery. We are past that stage. Only the printing presses can rescue us, and the ECB refuses to print. Tactically, Mr Brown erred gravely by promising "the biggest fiscal stimulus the world has ever seen". It is not his gift, and comes ill from a deadbeat state that cannot sell its own bonds.

i think it misunderstands the point of summits like this one to expect action. at best, summits are institutional reinforcers. moreover, i deeply disagree with evans-pritchard on the need and presumed efficacy of quantitative easing -- government fiscal commitments on the order of the rise in domestic savings and debt retirements are all that can work in an environment of collapsing loan demand to prevent a corresponding collapse in credit and monetary aggregates. there is going to be a contraction in demand regardless, as much excess demand was being called forward in time by a massive expansion in private debt. government cannot hope to finance a continuing expansion of debt, only a refinancing of existing debt onto the public balance sheet over time as the private sector moves to pay it down. but the need of that refinancing is absolute, and monetary policy cannot achieve it.

i do certainly agree however that, by being unable to convince germany and therefore the european union to move away from the restrictions of the maastricht treaty, later codified with a lovely bit of institutional irony in 'the stability and growth pact', the world will see the epicenter of the global collapse move to europe.

[L]ast week Brussels fired anathemae at Greece, Spain, France, Britain and Ireland, for breach of the 3 per cent deficit rule. We must retrench under Regulation 1466/97. Laugh not.

Germany's finance minister, Peer Steinbruck, is still digging in his heels against "crass Keynesianism". No matter that his economy will shrink 6-7 per cent this year. Germans must sweat it out: some more than others. Unemployment may reach five million in 2010. No doubt spending is a poor instrument, and we are all sick of bail-outs. But Mr Steinbruck might brush up on history. It was the deflation of 1930-1932 – not the hyperinflation of 1923 – that killed Weimar democracy. (Communists and Nazis won half the Reichstag seats in July 1932). The neo-Marxist Linke Party is already angling for 30 per cent in June's Thuringia poll.

You may agree with Mr Steinbruck. Fine. Capitol Hill does not. The most protectionist Congress since Bretton Woods is not going to acquiesce as precious US stimulus leaks abroad to the benefit of "free-riders". Patience will snap. "Buy American" is already US law.

The risk is that this G20 becomes the defining moment when a disgusted American political class – sorely provoked – turns its back on the open trading system. The US alone has the strategic depth to clear its own path, and might find eager partners in a "pro-growth bloc" – much as Britain led a reflation bloc behind Imperial Preference in the early 1930s. As the world's top exporters, Germany and China should take great care to restrain their body language this week.

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"i deeply disagree with evans-pritchard on the need and presumed efficacy of quantitative easing"

Do you consider QE to be worthless or actually damaging? I think it won't help fight deflation but that it can help keep nominal interest rates low...

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i don't have a powerful case for damaging, hbl -- but i wouldn't rule it out on correlation. to wit:

BoE began QE a few weeks ago. by putting a huge bid in on the gilt market, it is artificially inflating the price (to lower yields). after a couple weeks, HM treasury experiences its first failed gilt auction in many years.

is that a conincidence? some have said britain is simply asking the market to buy too much debt, but i'm not so certain that's true. i think the problem may be that QE had simply made gilts too dear, and treasury set the stopout yield too low. in other words, a market distortion created by QE may have resulted in a failed government debt auction.

but this is of course correlation, not firm causation. and britain is very definitely faced with massive foreign short-term debt rolls that could be very problematic. still, i wonder.

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I could see what you say being the explanation... However personally I think it more likely that we are in a peak period of investor panic that QE and other government stimulus will cause runaway inflation, and that once deflation asserts itself more firmly, that sovereign debt yields will become less volatile and settle somewhat at potentially lower yields. And QE does reduce the supply of assets on the market, which over time should be price supportive.

To me one of the most under-discussed dynamics to watch for though will be whether gold crashes if we experience a severe deflation, or whether enough people will be willing and able to keep holding it as "insurance" or "money" no matter what.

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gold would seem vulnerable to me, hbl, but i'm from the united states. there are other places in the world where an icelandic outcome is more easily envisioned -- including the UK -- and demand for metals in those societies could sustain or even drive up prices even in dollar terms.

walter rouleau used to say in growth fund guide that gold tended to outperform in periods of financial stress, either inflationary or deflationary. the psychology of uncertainty might be enough.

And QE does reduce the supply of assets on the market, which over time should be price supportive.

for a time, except that the market also has to anticipate that the gilts will be sold back into the market eventually to soak up excess reserves once loan demand starts to return. still, i'm with you on the call -- yields should continue to come down as loan demand stays low for longer than most expect now and banks get healthier.

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Agreed on the international gold demand factor, it may trump everything else.

Regarding selling back sovereign debt as loan demand returns... Have you read Steve Keen? If I understand correctly he thinks aggregate debt levels are too high for any recovery without eventual large scale debt repudiation, however unthinkable the concept is now. Shuffling debt between public and private balance sheets doesn't change its total burden on the economy. FYI, I consider Keen, Koo and Roubini as the top three public-facing economists regarding understanding this crisis.

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only a little bit on keen, hbl -- i should read more.

i do think (per koo) that fiscal stimulus should keep wholesale financial collapse at bay provided governments get on board with it in a more serious fashion. (not a given, of course.) in that scenario, economic acivity would stay high enough to the private sector to remediate over time, and post-remediation growth could begin from a much higher level. that should allow gov't to pay down debt with alacrity from there, a la britain post-1945. the return of loan demand would also allow for inflation to return, making possible an orchestrated 'soft default'.

but i also think this would clearly revise some things about our future government obligations that some of us take for granted now, such as medicare and SSA.

does keen speak to those points particularly?

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I agree that fiscal stimulus is important to keep collapse at bay, though there is a good chance as you say that governments will not understand the scale needed. But as Keen will point out, real GDP must fall, since debt levels must either stagnate or decline (much of recent growth has been at unsustainable ponzi levels predicated on forever rising asset prices), and debt growth has contributed around 20% of GDP per year to aggregate demand. (With "demand" in this case composed of both investment and spending demand combined).

I have not seen Keen go into too much detail on the shape of the future -- he focuses more on financial crises and how they develop and his predictions are rarer. But you may find something in his papers or posts. My guess is the big problem with the potential for the private sector to remediate over time is that:
(a) the existing debt will compete with new investments and crowd them out to some degree
(b) servicing the existing debt will be a huge drag on spending power (whether in the form of taxes, private mortgage payments, etc)

Hence the debt repudiation theme. After all Japan's debt-to-GDP has not gotten any smaller, when government is included, even after two decades.

The other way to look at resolution is massive transfer payments and a seismic shift in the gini coefficient to alter aggregate spending potential, but in essence that's roughly equivalent to debt repudiation.

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debt growth has contributed around 20% of GDP per year to aggregate demand. (With "demand" in this case composed of both investment and spending demand combined).

important point this, and why no one should expect a no-contraction scenario no matter what is done.

still, i wouldn't think a) and b) are serious impediments. there's little to crowd out, which is why there's a crisis. and aggregate debt service should actually get much cheaper in moving to treasury rates at a time when those rates are approaching zero.

there's this trick in not inducing a run on the international debt and currency, a problem japan didn't have due to very high domestic savings pool and low foreign ownership of japanese assets. britain famously faced a series of runs in the depression that forced it to devalue, as did the united states, germany and others in 1931. (see krugman's chart.) this is a huge wild card, imo, and it could well be triggered by trying to float more debt than can be financed out of increased domestic savings -- to, say, bail out banks. (better to suspend mark-to-market, at least insofaras it applies to regulatory capital, and allow the banks to earn on net interest differential over time.)

maybe keen is talking about something along these lines? these countries did devalue by 40% or so in the end and that does basically constitute a partial default of the sovereign.

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Regarding currencies, for some reason, at least so far, surprise rapid declines in the dollar still seem improbable to me in the context of much of the world's problems being as bad or worse. (I suppose intentional devaluation is a risk, but with some currencies pegged and retaliation by others assured...?) Or if a currency/debt run does happen my sense is it would be in the context of a much larger problem (global war, complete financial meltdown, etc).

The only explicit example I think I remember Keen giving regarding debt repudiation was mortgage principle reductions (I don't remember if he went as far as to say elimination). Also though I think it's obvious, to be clear my responses above did extrapolate beyond what I understand of Keen's opinions.

Speaking of meltdown, I guess George Soros isn't one of those who just proclaimed the bottom was in! Chilling stuff.

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