'World is trapped in low growth; there is no magic cure'
Do the world's economic managers know what they are doing? And will their medicine - of easy money - really work? Satyajit Das has his doubts.
SatyajitDasis an internationally renowned derivatives expert.His works include Swaps/Financial Derivatives Library, a four-volume, 4,200-page reference work for practitioners on derivatives, and the best-selling Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives. His latest bookExtreme Money - Masters of the Universe and the Cult of Riskdeals with the messy details of the 2008 financial crisis, the lessons from which have still not been learnt.
In this freewheeling interview with Vivek Kaul, he talks about how the world is trapped in a slow growth cycle and how cheap money is more likely to set off asset price bubbles than stimulate growth when people are trying to cut debt levels. This in the second and concluding part of the interview, the first part being published on Saturday (read here).
In a recent column you wrote "Mr Economy has...not made the recommended changes necessary for a return to full health". Could you elaborate on that?
The economic and financial problems of the global economy have a number of inter-related causes and these have barely begun to be addressed. Excessive debt was one of the problems. But five years on, borrowing levels remain unsustainable. Debt levels for 11 major nations have increased from 381 percent of GDP in 2007 to 417 percent of GDP in 2012. Debt has increased in Canada, Germany, Greece, France, Ireland, Italy, Japan, Spain, Portugal, the UK and the US. There has been a shift of debt from private lenders to governments. But that just shifts the problem and has triggered the sovereign debt crisis.
Have other causes been addressed?
Another cause was global imbalances - major current account surpluses and deficits with China, Japan and Germany exporting more than they import. There has been some improvement because of the slowdown in economic activity and the reduction in the availability of financing. But the large exporting countries remain resistant to abandoning their export-based economic model. Excessive financialisation (debt, complex products, etc) was another factor.
Little progress has been made in bringing the banking system under control. In fact, low interest rates and poor returns in many asset classes has set off a new boom in financial products - even things like CDOs (collateralised debt obligations) are now coming back into fashion. Most importantly, the world hasn't learnt that perpetual growth and improvements in living standards driven by financialisation is not sustainable. But just because you ignore the facts doesn't mean that they go away.
You recently wrote "physical examination revealed that the US is in marginally better condition than other organs - the "cleanest dirty shirt" is the expression." What do you mean by that?
People have been quick to proclaim the Chinese or BRIC century. I would be cautious about that. I think the US will do better than most people think, although they will not be immune to some of the broader issues. The US remains the world's largest economy, around 25 percent of global GDP, almost twice the size of China, the second largest economy. America remains relatively wealthy, with per capita GDP of around US$50,000, five or six times China's per capita income. The US has significant financial assets despite losses caused by the financial crisis. Structurally, the US can function better because it can operate successfully as a closed economy.
What do you mean by that?
America's economy is focused on its large domestic market. It is less exposed to trade (around 15 percent of GDP) than other large economies. American dominates key 21st century industries, such as technology and software, pharmaceuticals, complex manufactured products (aerospace, defence hardware, heavy machinery), entertainment and services. The US remains a major food producer. It is a net exporter of food, controlling almost half of world grain exports. It is also rich in mineral resources. Historically dependent on oil imports which make a substantial part of its $600 billion trade deficit, the US is cutting imports and increasing its energy independence through increased production of shale gas and oil.
The US also has greater policy flexibility. The US dollar remains the world's reserve currency. The US borrows in its own currency. There is a ready market for its securities, both domestically and internationally. The US also has favourable demographics. It has high population growth relative to other industrialized countries, which have below-replacement fertility rates. Also, it is worth remembering that the US is, by a considerable margin, the pre-eminent global military power.
How do you view things in Europe? Do you see the euro surviving?
The survival of the euro is an unproductive tangent, beloved of commentators. Whether or not it survives is largely irrelevant. Most European countries have high debt levels, budget and trade deficits, social spending inconsistent with tax revenues and poor industrial competitiveness (with some exceptions). They are tied together by a rigid monetary system and inflexible currency arrangements. The European banking system has large exposure to sovereign bonds issued by peripheral nations. Intellectually and institutionally, Europe is unable to deal with its debt crisis.
Europeans believe stabilisation and recovery can be achieved through greater integration. Even if issues of national sovereignty can be overcome, integration will not work. Unsustainable levels of debt do not magically become sustainable by changing the lender or guarantor. The monetary arithmetic of European debt problems is that the EU and Germany, its main banker, do not have enough funds to rescue the beleaguered eurozone members. Austerity would doom Europe to a prolonged and severe recession as the debt burden is worked off. The alternative, a debt write-off, would result in a significant loss of wealth for the mainly Northern European lenders, triggering an economic contraction and prolonged period of economic stagnation. It's Catch-22.
You recently wrote " Mr Economy is delusional, believing complete recovery is imminent. Presented with contrary evidence, you quoted philosopher Friedrich Nietzsche: "There are no facts only interpretations". Could you elaborate on that?
Everyone now sees what they want to see in the news flow and policy announcements. Financial markets have largely decoupled from the real economy. Investors have this Pavlovian reaction to interest rate cuts and further quantitative easing. Firstly, other than lowering the cost of carry, these cuts are meaningless outside the specific assets that the central banks are buying. Secondly, the policy actions are a response to low growth, poor investment, unemployment, etc, all of which are negative for risky assets. Thirdly, there is minimal evidence that the low rates, etc, are actually having much effect. Yet, everybody believes that they are the right remedy. Strange!
You quote economist Wynn Godley: "Governments can no more control stocks of either bank money or cash than a gardener can control the direction of a hosepipe by grabbing at the water jet". Why do you say that?
To cure a disease you need to be able to diagnose it. Then, the treatment has to be reliably effective. Economics and economic policy lack these critical criteria. We know very little about how economies work. Our models are inexact - a former Goldman Sachs quant and a trained physicist Emmanuel Derman once pointed out that no one in finance and economics actually knew what a good model (in the sense that it applies in science) looks like. For example, we are still arguing about what caused the Great Depression and whether the policy measures - Keynesian spending, etc - actually worked. Our tools - fiscal and monetary policy - are also limited, especially currently. Keynesians want government spending financed by taxation or borrowing to restore Mr Economy's health. But there is no evidence that it can arrest long-term declines in growth.
Could you elaborate on that?
Government spending boosts activity temporarily, but may create excess capacity in the absence of underlying demand. Nostalgia about President Roosevelt's infrastructure projects during the Great Depression is misplaced. Excess electricity generation capacity from dam projects was only absorbed by wartime demand for defence equipment. In any case, as tax revenues have fallen due to slower economic activity, governments have already borrowed to finance large budget deficits. Governments' ability to borrow to finance further spending is increasingly limited, without resort to innovative monetary techniques. The limits of government's ability to borrow and spend are highlighted by the European debt crisis. Investors are increasingly concerned about public finances, becoming reluctant to finance nations with high levels of debt or demanding high interest rates.
That's a very different point of view...
Having reduced interest rates to zero, central banks are changing the quantity of money. Central banks believe that they can keep rates low and print money to finance government debt purchases indefinitely. But greater government spending, lower rates and increased supply of money may not boost economic activity. Crippled by existing high levels of debt, low house prices, uncertain employment prospects and stagnant income, households are reducing, not increasing, borrowing. For companies, the absence of demand and, in some cases, excess capacity, means that low interest rates are unlikely to encourage borrowing and investment. The policies also have serious and destabilising side effects - new asset bubbles are being set off.
Could you explain this in detail: "Mr. Economy now has a serious chronic condition with limited prospects of a full cure? He might continue to live but in an impaired state of no or low growth for a prolonged period. The threat of a sudden life threatening seizure cannot be discounted. Constant management will be needed."
Despite all the policy debate, I think there is no way out of this. We are now trapped in a period of low growth as we try to work off the excessive debt. There is no magic cure. The analogy is that you have a chronic but incurable condition and you need to manage it, but there is always the risk of a life threatening episode. You just are hoping you have enough drugs - printing presses to create money - to manage the slide. That's it. Whether this is doable or not, I have no idea. It has never been done on this scale. Japan is the closest analogy. Also what this means in terms of social cohesion and the ability to maintain democracies are unknown. How can countries live with 25 percent unemployment (50 percent plus for under 25s) and for how long? We are not talking about an economic problem any more - you are talking about a profound test of society and the political system. That is what has to be managed. I hope our masters know how to do this!
One of the first things you say in Extreme Money is that "modern economies have ceased to make anything". Why do you say that?
There was a shift from real engineering to financial engineering. It has several different elements. The UK was once the centre of manufacturing in the world. What does it make today? It is an economy built mainly on the financial services sector, property and services. The US makes more but has moved the bulk of their manufacturing offshore, to places like China and India, where it is cheaper. Individual businesses also have become financialised. At one level, firms used financial engineering - mergers and acquisitions, rejigging capital structures with more debt, share buybacks - to boost stock prices. It was also about financial services becoming integral to businesses - vendor financing of sales of cars, trucks or industrial equipment, trading assets to make money, etc. The reinvention of GE under Jack Welch, whereby GE Capital (which is like a financial institution) came to dominate the business, is a good example of this.
You write "business improvements are risky and very slow, akin to watching grass grow. *Financial changes are easier, more predictable and, most important quicker." Can you elaborate on that?
Making money from real businesses - new products, investing, managing, operational improvements - takes time. Financial engineering is easier and a lot quicker. For example, in the 1980s the yen appreciated, creating havoc amongst Japanese exporters, who were reliant on the cheap yen for competitiveness. Exporters changed strategy, moving production facilities offshore. Unfortunately, you cannot move a car plant to Mobile, Alabama, overnight. Japanese companies used financial speculation to cover up the weak profitability of their businesses. More recently, in January 2011, the Japanese carmaker Honda announced losses of 15 billion ($180 million) from trading in shrimp and shellfish. There is a well-worn joke: "'How many workers does it take for Toyota to make a motor car?' Answer: 'Four. One to design it, one to build it and two to trade the long bond.'"
You write, "In their song Once in a Lifetime... David Byrne and The Talking Heads asked the question of the times: 'How did you get that large automobile, the beautiful house, and the gorgeous wife?'" What's this got to do with the financial crisis?
Underpinning the crisis is the fact that people wanted to get better living standards. Economic growth driven by financialisation was a means to that end. So the question that Byrne asked was the question everyone should have asked - how could we have got these things without the money and without seemingly have had to work for it. The fact is that much of the world didn't pay its way. They borrowed from thrifty Asians and Germans to fulfil their needs for instant gratification. Unfortunately, it means that the borrowers are in trouble but ultimately the savers will have to pay for it all as governments wipe out their savings - either through financial repression, such as a low interest rates or high inflation.
Has the world learnt from the mistakes it made leading to the financial crisis?
No, not really. We keep repeating the same mistakes over and over. Hegel was correct when he observed that the only lesson of history is that no one heeds the lesson of history.
Vivek Kaul is a writer. He can be reached at email@example.com
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In a further blow to policymakers battling a raging debt crisis, the downturn that began in the eurozone's smaller economies has become entrenched in the core countries of Germany and France.
It seems the European Union has all-or-nothing treaties: if you want to exit the euro, you have to exit the EU as well.