Monday, April 12, 2010

Economics 12/04/2010: The next incoming train has left its first station

My current article on the longer term prospects for global economy, published in the current issue of Business & Finance magazine. This is an unedited version.

Forget the circus of the Euro zone Government’s bickering about Greece’s bailout package and the escapist idea of setting up the EU-own EMF. The real crisis in the Euroland is now quietly unfolding behind he scenes.

Finally, after nearly 15 years of denial, courtesy of the severe pain inflicted by the bonds markets, Brussels and the core member states are forced to face the music of their own making. The current crisis affecting Euro area economy is, in the end, the outcome of a severely unbalanced economic development model that rests on the assumption that exports-led economic expansions in some countries can be financed through a continued massive build up in financial liabilities by their importing partners.

Put more simply, the problem for the world going forward is that in order to sustain this economic Ponzi game, net importers must continue to finance their purchases of goods and services from net exporters by issuing new debt. The debt that eventually settles in the accounts of the net exporters.

One does not have to be versed in the fine arts of macroeconomics to see that something is wrong with this picture. And one does not have to be a forecasting genius to understand that after some 40 years of rising debts on the balance sheet of importing nations, the game is finally up. I wrote for years about the sick nature of the EU economy - aggregate and individual countries alike.

Last week, Lombard Street Research's Charles Dumas offered yet another clear x-ray of of the problem.

Lessons and Policy Implications from the Global Financial Crisis; <span class="blsp-spelling-error" id="SPELLING_ERROR_3">Stijn</span> <span class="blsp-spelling-error" id="SPELLING_ERROR_4">Claessens</span>, Giovanni Dell’<span class="blsp-spelling-error" id="SPELLING_ERROR_5">Ariccia</span>, <span class="blsp-spelling-error" id="SPELLING_ERROR_6">Deniz</span> <span class="blsp-spelling-error" id="SPELLING_ERROR_7">Igan</span>, and <span class="blsp-spelling-error" id="SPELLING_ERROR_8">Luc</span> <span class="blsp-spelling-error" id="SPELLING_ERROR_9">Laeven</span>; IMF Working Paper 10/44; February 1, 2010

Source: Lombard Street Research, March 2010

As Dumas' chart shows, core Euro area economies are sick. More importantly, this sickness is structural. With exception of the bubble-driven catch-up kids, like Spain, Ireland and Greece, the Euro area has managed to miss the growth boat since the beginning of the last expansion cycle.

The three global leaders in exports-led growth: Germany, Japan and Italy have been stuck in a quagmire of excessive savings and static growth. Forget about jobs creation – were these economies populations expanding, not shrinking, the last 10 years would have seen the overall wealth of these nations sinking in per capita terms. Only the Malthusian dream of childless households can allow these export engines of the world to stay afloat. And even then, the demographic decline will have to be sustained through disposal of accumulated national assets. So much for the great hope of the exports-led growth pulling us out of a recession. It couldn’t even get us through the last expansion!

Over the last decade, the Sick Man of Europe, Italy has managed to post no growth at all, crushed, as Dumas’ put it, by the weight of the overvalued and mismanaged common currency. The Sick Man of the World, Japan has managed to expand by less than 0.8% annually despite running up massive trade surpluses. Germany’s ‘pathetic advance over eight years’ adds up to a sickly 3½% in total, or just over 0.3% a year. France, and the UK, have managed roughly 0.98% annualized growth over the same time. Comparing this to the US at 1.27% puts the exports-led growth fallacy into a clear perspective.

I wrote in these pages before that the real global divergence over the last 10 years has been driven not by the emerging economies decoupling from the US, but by Europe and Japan decoupling from the rest of the world. The chart above shows this, as the gap between European 'social' economies wealth and income and the US is still growing. But the chart also shows that Europe is having, once again, a much more pronounced recession than the US.

Europe's failure to keep up with the US during the last cycle is made even more spectacular by the political realities of the block. Unlike any other developed democracy in the world, EU has manged to produce numerous centralized plans for growth. Since the late 1990s, aping Nikita Khruschev's 'We will bury you!' address to the US, Brussels has managed to publish weighty tomes of lofty programmes - all explicitly aimed at overtaking the US in economic performance.

These invariably promised some new 'alternative' ways to growth nirvana. The Lisbon Agenda hodge-podge of “exporting out of the long stagnation” ideas was followed by the Social Economy theory that pushed the view that somehow, if Europeans ‘invest’ money they did not have on things that make life nicer and more pleasant for their ageing populations growth will happen. Brussels folks forgot to notice that ageing population doesn’t want more work, it wants more ‘free’ stuff like healthcare, public transport, social benefits, clean streets, museums and theatres. All the nice things that actually work only when the real economy is working to pay for them.

As if driven by the idea that economic development can be totally divorced from real businesses, investors and entrepreneurs, the wise men of Europe replaced the unworkable idea of Social Economy with an artificial construct labelled ‘Knowledge Economy’. This promised an exports-led growth fuelled by sales of goods and services in which we, the Europeans, are supposedly still competitive compared to our younger counterparts elsewhere around the world. No one in Brussels has bothered to check: are we really that good at knowledge to compete globally? We simply assumed that Asians, Americans, Latin Americans and the rest of the world are inferior to us in generating, commercializing, and monetizing knowledge. Exactly where we got this idea, remains unclear to me and to the majority of economists around the world.

The latest instalment in this mad carousel of economic programmes is this year's Agenda 2020 – a mash of all three previous strategies that failed individually and are now being served as an economically noxious cocktail of policy confusion, apathy and sloganeering.

But numbers do not lie. The real source of Euro area's crisis is a deeply rooted structural collapse of growth in real human capital and Total Factor productivities. And this collapse was triggered by decades of high taxation of productive economy to pay for various follies that have left European growth engines nearly completely dependent on exports. No amount of waterboarding of the real economy with cheap ECB cash, state bailouts and public deficits financing will get us out of this corner.

The real problem, of course, is bigger than the Eurozone itself. Exports-led economies can sustain long-run expansions only on the back of a borrowing boom in their trading partners. It is that simple, folks. Every time a Mercedes leaves Germany, somewhere else around the world, someone who intends to buy it will either have to draw down their savings or get a loan against future savings. Up until now, the two were inexorably linked through the global debt markets: as American consumers took out loans to buy German-made goods, Chinese savers bought US debt to gain security of their savings.

This debt-for-imports game is now on the verge of collapse. Not because the credit crunch dried out the supply of debt, but because the global debt mountain has now reached unsustainably high levels. The demand for more debt is no longer holding up. Global economic imbalances remain at unsustainable levels even through this crisis and even with the aggressive deleveraging in the banking systems outside the EU.

Take a look at the global debt situation as highlighted by the latest data on global debt levels. The first chart below shows the ratio of net importing countries’ gross external debt liabilities (combining all debts accumulated in public and private sectors, including financial institutions and monetary authorities) to that of their net exporting counterparts. The sample covers 20 largest importers and the same number of largest exporters.

Source: IMF/BIS/World Bank joint data base and author own calculations

As this figure illustrates, since mid-point of the last bubble at the end of 2005, the total external debt burden carried by the world’s importing countries has remained remarkably stable. In fact, as of Q3 2009, this ratio is just 0.3 percentage points below where it stood in the end of 2005. Compared to the peak of the bubble, the entire process of global deleveraging has cut the relative debt burden of the importing states by just 9.8%.

To put this number into perspective, while assets base of the world’s leading economies has fallen by approximately 35% during the crisis, their liabilities side has declined by less than 10%. If 2007 marked the moment when the world finally caved in under the weight of unsustainable debt piled on during the last credit boom, then at the end of 2009 the global economy looked only sicker in terms of long-run sustainability.

The picture is more mixed for the world’s most indebted economies.
Plotting the same ratio for the US and UK clearly shows that Obamanomics is not working – the US economy, despite massive writedowns of financial assets and spectacular bankruptcies of the last two years remains leveraged to the breaking point. The UK is fairing only marginally better.

Of course, Ireland is in the league of its own, as the country has managed to actually increase its overall s
Lessons and Policy Implications from the Global Financial Crisis; Stijn Claessens, Giovanni Dell’Ariccia, Deniz Igan, and Luc Laeven; IMF Working Paper 10/44; February 1, 2010hare of global financial debt during this crisis courtesy of an out-of-control public expenditure and the lack of private sector deleveraging. Take an alternative look at the same data. Ireland’s gross external debt (liabilities) stood at a whooping USD 2.397 trillion in Q3 2009, up 10.8% on Q3 2007. Of these, roughly 45% accrue to the domestic economy (ex-IFSC), implying that Irish debt mountain stands at around USD 1.1 trillion or more than 6 times the amount of our annual national income.

Chart below shows gross external debt of a number of countries as a share of the world’s total debt mountain
Source: IMF/BIS/World Bank joint data base and author own calculations

And this brings us to the singularly most unfavourable forecast this column has ever made in its 7 years-long history. Far from showing the signs of abating, the global crisis is now appearing to be at or near a new acceleration point. Given the long-running and deepening imbalances between growth-less net exporting states, like Germany, Japan and Italy and the net importers, like the US, we are now facing a distinct possibility of a worldwide economic depression, triggered by massive debt build up worldwide. No amount of competitive devaluations and cost deflation will get us out of this quagmire. And neither a Social Economy, nor Knowledge Economics are of any help here.

Paraphraisng Cypher in the original Matrix
Lessons and Policy Implications from the Global Financial Crisis; Stijn Claessens, Giovanni Dell’Ariccia, Deniz Igan, and Luc Laeven; IMF Working Paper 10/44; February 1, 2010: “It means fasten your seat belt, Dorothy, ‘cause Kansas of debt-financed global trade flows is going bye-bye”.
Lessons and Policy Implications from the Global Financial Crisis; Stijn Claessens, Giovanni Dell’Ariccia, Deniz Igan, and Luc Laeven; IMF Working Paper 10/44; February 1, 2010
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