Stimulus and the growth which is not happening

Many people are asking themselves what is happening to the global economy and why, despite easing from the main Central Banks, the world is not growing as it did before the crisis.

We are facing a time of global debt reduction. Debt levels had grown abnormally because of exceedingly low real rates originated by erroneous mechanisms such as the so-called ‘Greenspan put’. An expansionary monetary policy (amplified by an increase in money velocity) without an increase in productivity can only lead to inflation. Growth sources are known, as it is trend growth (see Barro and Sala-i-Martin, Economic Growth). Keeping growth systematically above trend is simply not possible. Trying to do so implies a period of negative growth, kick-started by deleveraging, which then reverberates in low growth for a protracted period of time. Historically deleveraging process have taken as much as a decade.

In some countries leverage has taken the shape of private and banking debt (as in the US and UK), in others of government debt (as in Italy), in yet others it has been a combination of the two. Spain is an example of high leverage in the private and banking sector which is translating into an increase of government debt, like in Ireland and similarly to the US, where for now systemic leverage is not being reduced: the burden is simply being shifted from the private to the public balance sheet. Not facing the problem of an increasing government debt means only inflating another bubble which will eventually blow. Consequences can be an increase of the interest the American government pays to finance its debt and probably loss of the status of global reserve currency for the Dollar. These dynamics, however, will take time to play out and the US still has time to find solutions.

A high level of leverage has implications similar to gearing in a firm: essentially gains are amplified provided they exceed the cost of financing, but losses are similarly increased when revenues are below financing costs.

It should be obvious, therefore, that growth rates of pre-crisis periods were too high and essentially ‘borrowed’ from future generations.

In Europe the Zeitgeist seems to finally be one of reducing debt, even at the cost of a lower GDP. This would rebalance the burden between older and younger generations. So far the young have paid more than what they could expect to collect in services from the State to keep promises governments had made to past generations.

This leads naturally to go beyond neo-Keynesian ideas, which seem to still prevail on the other side of the Atlantic. Let it be clear the Keynes himself would not approve of an economic policy based on permanently high levels of debt and spending.

It should be clear to proponents of so-called Keynesian theories (which Keynes would today oppose) that a phase of contraction is inevitable after a period of growth artificially kept above trend by inconsiderate monetary and fiscal policies.

It is not possible to grow by inflating bubble after bubble and not expect consequences in the long run. If it true that Keynes said ‘in the long run we are all dead’, it looks like he is dead, and the ‘long run’ is now.

The world is unlikely to go back to a sustainable level of growth before having gone through a reduction of debt levels which allows to re-start for a reasonable basis.

Recent studies, such as the famous book ‘This time is different’ by Reinhart and Rogoff, found that Debt-GDP ratios in excess of 90% lead to yearly growth levels on average 1.5% lower.

It is up to us, now, to right this wrong, without looking for excuses or blaming ‘bad and ugly’ speculation (which was fine until it pushed prices up).

Common sense tells us this even before Keynes (not the Keynesians, who keep thinking debt is not a problem, until it is: and then you’re in trouble), Minsky (‘Stabilising an unstable economy’), Hayes (‘Theory of Money and Credit’) and lately Sedlacek (‘Economics of good and evil’) and Niall Ferguson (‘The ascent of money’).

Those who squandered the resources of current generations in the past to ingratiate themselves with electors easily convinced by the adage ‘the money exists’, should keep in mind that the judgment of History will not be lenient. And it will be even less lenient with those who still today are living off these illusions.

Increasing debt would cost too much (finally people start understanding this). increasing taxes would lead to lower income for the State for the effects of the Laffer curve (or lower disposable income for those who do not like this theory). But above all remember what Thomas Jefferson said:

 "The democracy will cease to exist when you take away from those who are willing to work and give to those who would not."

In Italy, but not only in Italy or Southern Europe, it is necessary to change the mentality of those who still think the State owes them everything, since the State takes form those who create wealth to gice to those who do not. It is time to stop this.

Oscar Wilde, chess players and the Euro

Oscar Wilde once wrote: ‘There are only two tragedies in life: one is not getting what one wants, and the other is getting it’.

A strategic thinker is one who is able to connect the dots between apparently unrelated events and think many moves ahead, thus calibrating his moves to at least minimise immediate damage and ripe benefits in the future. The typical example outside the battlefield is a chess player: it is said that the very best can see 20 or more moves ahead.

Most of the comments made by German officials since the start of the crisis have been unfortunate for the seeming incapacity to see even 2 or 3 moves ahead.

One of the latest, however, deserves the Oscar, not least because it was expressed in written form, and can therefore hardly be open to misunderstandings.

Michael Meister, a senior member of Merkel's party, wrote on Twitter: "no one is preventing Hollande going ahead with joint bonds for France and (Italian Premier Mario) Monti for Italy."

Seemingly not a chess player, it is probable that Mr Meister has also failed to connect his brain before getting online. Had he done so, he would have been able to think some moves ahead and get to the logical conclusion that a joint bond issuance of any group of countries within the Euro but excluding Germany would have.

 It is by now clear to most that the German balance of trade is in surplus largely because of the advantage of an undervalued currency. Indeed, if Germany were to return to the Deutsche Mark, the new currency would increase 30-40% on the Euro according to some conservative estimates, thus wiping out (with probably plenty to spare) the trade surplus more or less overnight.

We can suppose Mr Meister knows this, as it has been widely reported in the press for several years.

If European countries, excluding Germany, were to issue joint bonds, it is not too far-fetched to assume that this would be done under condition that they, and they alone, share the same currency. In other words, this would imply either that said countries leave the Euro or that Germany, willingly or more probably not, would be shown the door.

This scenario could play out before or after the issuance, but either way it is the most probable outcome of the event Mr Meister is advocating.

Italian Prime Minister Monti, one of the few international leaders who understands economics, answered indirectly during a TV show, saying that all stand to lose from a dissolution of the Euro, but Germany stands to lose the most, as Italian exports with a competitive currency would be trouble to German firms. It is exactly as simple as that: Italy has a positive primary balance of trade, which means it exports more than it imports. The balance of trade is only negative because of debt interest payments. Truth is, Italy would export a lot more with a cheaper currency. It would also pay more for its imports, but also benefit from inflation effectively lowering debt burdens in real terms. Before anyone thinks leaving the Euro is a good idea for Italy, please consider that it would come at the cost of bank and business defaults and everyone (but debtors like the State) would be made poorer by inflation (see previous post: http://linesofanalysis.blogspot.it/2011/12/reductio-ad-absurdum-why-euro-will-not.html).

Populist comments like Mr. Meister’s are most probably made not so much because of ignorance of things economic (if we know the numbers in Tuscany and Milan, it is obvious they known them in Berlin and Frankfurt, even if most politicians are lawyers with limited understanding of figures), but most probably to assuage the mood of the Germans who, because nobody took the time to explain them how the numbers look, want nothing more than their old Deutsche Mark. To this, Oscar Wilde’s quote is very appropriate: it would be a tragedy indeed, mostly for them as jobs would disappear with their hard-earned competitiveness, to get what they want. Or Merkel can do her job and explain the numbers to her constituents.