Guest writer George Magnus is senior economic advisor for UBS Investment Bank, and has also worked with Lloyds, Bank of America, U.K. stockbroker Laurie Milbank, and merchant bank S G Warburg. He is author of the book The Age of Aging: How Demographics Are Changing the Global Economy and Our World, and he is currently working on a new book, Uprising: Will Emerging Markets Shape or Shake the World?
It’s not easy being an investor in the post-crisis world. One minute, risk premiums in equity and other risk markets are back to where they were before the crisis. The next minute, there are hints of Chinese policy tightening and President Obama puts forth proposals to control the size and risk of banks (like Bank of America
The jump
Economic recovery since the 2009 abyss -- when financial markets were priced for massive global bankruptcy-- has been particularly marked in emerging markets, but it has spread around the world thanks to unprecedented financial, monetary, and fiscal measures. Emerging markets quivered momentarily, with some experiencing large double-digit declines in exports and output. However, most of Asia and some countries in Latin America had already been through a painful balance-sheet recession between 1997 and 2001, and were therefore financially strong enough to absorb and offset the 2008-09 shock.
In the U.S., Japan, and Europe, though, we’re seeing a balance-sheet recession (which is just another term for protracted and painful deleveraging). Despite the rise in GDP and the pick-up in high-frequency economic indicators, nothing can disguise this underlying fact. This makes the economic recovery more of a bungee jump. Every economy fell off the edge of a precipice, and while Asia and some other emerging countries have bounced back to the top, advanced economies haven’t the momentum. We are woefully short on growth drivers.
U.S. woes
The U.S. banking system remains largely dysfunctional, even though systemic risk has been greatly reduced. It will take a long time for the banking sector to shrink and to cut loose the bad assets that still clog up its balance sheets. Moreover, there is little question that politics and policy are going to propel banks further in this direction. So we have lost leverage as a growth driver. Maybe this is not a bad thing, but as of yet we haven’t found substitutes.
We have lost households as a growth driver as well, because the household debt burden also became excessive -- and one way or another, debt has to be destroyed or restructured. In the U.S., we have already seen a record-breaking run of quarters in which household liabilities have fallen to go along with corporate- and financial-sector deleveraging. We have lost employment and wage and salary income as growth drivers because of cost-cutting, deleveraging, and a poor prognosis for capital spending. And lurking behind this is a more glacial, but important phenomenon: aging populations. Simply put, we have started to lose the baby boomers who swelled labor input, income, and credit over the last 25 years. The U.S. is in far better shape than the U.K., Europe and Japan, but is nonetheless affected.
Most immediately, though, economic growth is going to be compromised by the withdrawal of governments and central banks from programs they put in place to stabilize a bad situation. Financial exit policies have already started in a low-profile way, but central banks will probably lean more heavily, and cautiously, in this direction as the year evolves. It’s unlikely, though, that interest rates will rise much, if at all, in the U.S. or the U.K. However, the European Central Bank may have slightly different ideas. Interestingly, though, policy tightening in emerging markets, such as China and India, has already begun, and is bound to continue, slowly or otherwise, to combat rising inflation.
Sovereign debt
The bigger exit problem is sovereign debt. To combat the worst financial crisis since the 1930s, we have transferred large private-sector debts to the public sector. The recession and the structural shock to the real-estate and financial-services sectors have caused government tax revenues to plummet. Some of these revenues are gone forever. There is no peacetime precedent for the speed or scale of this increase in public debt, and although there are precedents for large fiscal adjustments in richer nations -- Canada, Ireland and Sweden, for example -- they occurred under much more favorable global circumstances. This time, we are all trying to retrench simultaneously. Moreover, unlike in prior government debt crises, we cannot cut interest rates any further. This will be a problem at a time of soaring debt service costs, because of the bloated levels of public debt. Most important of all, no one knows where the threshold is between structural budgetary reform and social and political instability. In Greece, it may have already been reached. In Portugal, Ireland, Spain, and even Italy, who knows?
The recovery
It will take bold and assertive leadership to navigate away from a fiscal crisis and distribute the costs equitably. The forthcoming UK election could prove a test case for the markets’ trust in effective leadership, as could the threatened logjam between U.S. Democrats and Republicans in considering meaningful deficit-cutting legislation in the medium term. The challenge will test the mettle of our political leaders and social and economic institutions. In the euro area, where countries do not have the option of exchange-rate depreciation to cushion the additional deflationary headwinds, the integrity of the single currency itself could eventually be at stake.
Investors will have to be wary about the policy risks in economic and investment decisions, and ensure that their judgements about risk premiums -- and what to pay for assets -- are appropriate to a world where simple valuations only tell part of the story. Investors will also have to take on the risk of a likely contagious spike in long-term interest rates, occurring as a result of fiscal inertia and debt financing interruptions.
Ultimately, we all face a decision between the muddle-through-cum-social-cohesion template followed by Japan since 1990, and a more radical approach to reform and renewal that involves taking some social and political risks. And who can be confident that Japan, now entering its third decade of rapid aging, will continue to be a template at all?
