Saturday, 6 August 2011

That S&P Downgrade. The Music's stopped.

It's important to understand exactly what the ratings agencies do. Their ratings are merely opinions. They are not regulators, though regulators take their work rather too seriously. They do not set rates - the market sets rates - though they take rather too seriously the ratings agencies' opinions, mainly because it allows lazy traders to price the risk of a given security according to their rating without doing that boring maths stuff, or any tedious analysis.

The USA is not about to go bust, but the deficit is rising, the debt is rising, and rising at an increasing rate. This is President Obama's "stimulus" program, and it has failed utterly, just as every other stimulus program everywhere has failed during this crisis. The problem is that of decades of Governmental overspend. In the USA the benefits of relatively low tax-rates are eaten almost entirely on increase health care costs, something Obamacare does almost nothing to address; it just moves the burden a bit from private to public. So the western world entered the financial crisis with Government spending between 40% and 50%, as Governments found it easier to deliver jobs by borrowing to build a bloated state bureaucracy and generous but inefficient state services.

During the cheap-money boom running from the late 90's to 2008 economic growth was accelerated by the money borrowed by Governments, and the money borrowed by people against the rising value of their homes. Public and private debt across the western world grew as Governments and home-owners spent cheap credit. It was the household debt, sliced and diced by ex-ratings-agency employees in ways to game the algorithms to generate the necessary grades to allow investors, who don't look too closely under the bonnet, to buy them.

House-price inflation is just inflation, but this was not captured in statistics used by the central banks to set interest rates. Gordon Brown chose CPI, which excludes most housing costs, instead of the far more appropriate RPI, which doesn't when setting the central bank free to set rates. As a result, British interest rates were too low during the 90's or 00's. Similar sleights of hand happened in the USA. Of course it was the private sector credit which went pop first - and the web of debt, and the financial instruments secured upon it fell apart and banks went bust. Ireland and Iceland were bankrupted by the cost of bailing out the banks.

A chunk, but not the lion's share of the UK's public debt is the cost of bailing out the banks. But the UK was running a deficit BEFORE the crisis, as was the USA. Governments were trying to keep the party running by borrowing money. Eventually the music stopped. The size of the UK's and Ireland's deficit is partially due to the collapse in Bank's tax-bills which had underpinned public spending. In the USA, the Bush-era tax-cuts (and discretionary war-fighting) are the main reasons for the deficits. the Bank bail-outs (and that of motor manufacturers!!!) were the main reasons in the US. Governments desperately trying to keep the music playing by pulling the "stimulus" levers on their monetary (low interest rates) and fiscal (excessive state spending) levers.

So the wheel came off the financial system, leading to lower tax receipts from that sector. The correct response would have been to cut spending to reflect the new reality. But for the last 2 years, countries with open economies and floating exchange rates, whose policy makers surely knew that the fiscal multipliers were probably less than one, sought to "support" the economy with continued state spending.

This attempt to keep the party going was doomed to failure. Now for the good news. The US and UK political systems and indeed democracy, are mature enough to call "enough". The Tea Party caucus stopped Obama's lunatic stimulus program and demanded a return to balanced budgets, and crucially they called for the majority of this fiscal contraction to come from spending cuts, not tax rises. In the UK the electorate was persuaded that ever more spending was not the answer and elected a Conservative-led coalition which had not shied away from the need for spending cuts. In the UK spending cuts are about to start, or "bite" as the BBC keeps telling us. This may be expansionary, if it means that confidence in money and the economy returns.

The UK and USA are going to be Okay. Our public finances will be brought under control. The USA will regain its AAA rating in time, and we may even experience growth while doing it. (This will surprise the Keynesian and the BBC).

The economies of Southern Europe don't have the excuse of bailing out banks for their crisis. That can be laid squarely at the door of the Euro, a political vanity project which is now destroying economies and lives, because sharing a currency doesn't make Greeks or Italians into Germans. The ultimate cause though is the same. Decades of cheap money artificially boosted the economy leading to an asset price boom. Governments unshackled from the constraints of the markets were able to borrow to buy votes, until bond traders noticed that the Greeks and Italians were not behaving like those parsimonious Germans and started to drive down the price of their bonds. The music has stopped, the money must be paid back, and Governments MUST cut their cloth according to their means.

Who's going to spend more to close the gap? Well that's obvious. The Japanese people have to start spending their savings (while their government reins in its spending). The Chinese government will find the returns available on its surplus heading to zero if it continues to buy dollars to keep the Yuan down. They will have to start running surpluses and let their currency appreciate.

It ain't all bad. The world has plenty of demand - 2 Billion south and east Asians are getting richer faster than ever before in the greatest expansion of wealth in history. Why aren't we celebrating this, and seeing it as an opportunity? What we need is Governments to realise they can't and shouldn't run deficits or surpluses for ever, and the less they manage the economy, the better that economy functions in the long-term. Indeed neither should people run surpluses for ever: You can't take it with you. The world's financial crisis are simply shocks which change behaviour to iron out these imbalances. It works, eventually.Link


Rudebwoi said...

An interesting post, however your take on Obama's healthcare plan is incorrect.

The Obama plan purported to reduce the budget deficit by close to USD 150 Billion. This figure, while significant, palls in comparison to Bush's financing of Medicare in 2003 to the tune of USD 180 Billion.

Please see the link below to a graph illustrating Obama and Bush's respective influence on the US Budget deficit.

Single acts of tyranny said...

I am not at all sure the Americans will be okay. The downgrade for them is desperate, why would you use the dollar as a reserve currency when it is no longer triple A and Bernanke has the presses printing wildly? I understand the Fed, not the Chinese is the purchaser of some 78% of T-bills, a suicide mission if ever there was one, but there is still no political will to cut spending. In some quarters of the US political spectrum, not even an understanding of the need to do so!

We live in interesting times.

It is worth noting that in 1920, the US government spending was $6.3B, by 1921 they had cut it to $5B and the recovery began, by 1922 it was cut to $3.2B, and the economy was powering ahead. Contrast that with FDR's idiot stimulus programs which prolonged the depression for a decade or more.

Jackart said...

Rudebwoi. You may be right, and I shall look into that. I haven't looked into Obamacare in detail. Perhaps I need to find out more.

The point I was making was that the low US tax take by government is entirely eaten up by private sector healthcare costs. Thus the lower US tax rates compared to illusuroy. From the tax-payers point of view, after tax and healthcare costs Europeans and Americans are in the same boat - government taking 40-50%.

Jackart said...

SAoT. It's so easy to be pessimistic. But governments or financial systems aren't people. Europeans and Americans remain educated, resourceful people who will find a way through this and continue to find ways to make and do things people value, if Governments get out of the way. Thanks to Governments bankrupting themselves, the Government has no choice but to get out of the way.

Mr Ecks said...

Dream on Jackart. The plastic-faced , EU-sucking traitor you love so much isn't up to it by a very long mile. Neither is Obamalamadingdong.

Conservative spending cuts bite?. What cuts--peanuts here and there while the overall debt rises--not as fast as under the mentalist but bloody fast enough.

The US isn't bankrupt but the fucking federal tyranny most certainly is. They will run the printing presses to try and get out from under even tho' they know how crazy it is.

Single acts of tyranny said...

Oddly enough I am not at all gloomy about this outcome having arranged the family affairs on such a prediction. I may of course be quite wrong, but fixed rate borrowing during an inflationary cycle should be fine, ditto holding liquid assets in various commodities. That said of Mervyn King is right about deflation, it could be awkward for me but when was the last time he was right about anything?

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