In today’s overleveraged world, greater deficits and government spending, financed by an expansion of public debt and the monetary base (“the printing press”), are not the answer to our economic woes. In fact, these policies have been proven to have a negative impact on growth. [Therefore] as long as we continue down this path, the “solution” will continue to be the problem. There is no miracle cure to our current woes and recent proposals by central planners risk worsening the economic outlook for decades to come. [Let us explain.] Words: 1510
So say Eric Sprott & Etienne Bordeleau (www.sprott.com) in edited excerpts from their recent article* entitled “The Solution… is the Problem Part II”.
Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!) has edited the article below for length and clarity – see Editor’s Note at the bottom of the page. This paragraph must be included in any article re-posting to avoid copyright infringement.
They go on to say, in part:
While it hasn’t received much attention in recent years, a wide body of economic theory suggests that government policies and their size relative to the total economy can have a significant detrimental impact on economic growth.
- For rich countries, there is overwhelming evidence of a negative relationship between a large government (either through taxes and/or spending as a share of GDP) and economic growth according to a recent paper from the Stockholm Research Institute of Industrial Economics.
- All else being equal, countries where government plays a large role in the economy tend to experience lower GDP growth….While the literature is not definitive on causation, it still provides strong evidence that more taxes and government spending as a share of GDP (except for productive investments such as education) is associated with lower growth.
One exception to these findings is the experience of Scandinavian countries.
- They have both high taxes and high government spending as a share of GDP but have experienced relatively rapid growth over the past 20 years.
- However, a significant share of their spending goes to education, which has been found to foster growth.
- They also counterbalance the large role of the state with very liberal, pro-market reforms and low levels of public debt.
Debt overhang and economic growth
Even if one believes that temporary Keynesian-type fiscal stimulus, in the form of tax breaks and increased government spending, can spur growth in the short-term, these actions inevitably lead to larger deficits and higher government debt.
- As Figures 1 and 2 below show, the U.S. Federal Government deficit and debt levels are already at their highest levels since the end of World War II and the scope of future stimulus appears to be rather limited.
- The U.S. federal debt will increase significantly as the deficit remains sustained and elevated according to our projections (which assume there will be no fiscal cliff). For many European countries the situation is even worse.
- High levels of debt, or debt overhangs, cause more problems. Recent work by Carmen Reinhart and Kenneth Rogoff (Harvard University) demonstrates that banking crises are strongly associated with large increases in government indebtedness, long periods of unemployment and, ultimately, some form of default. They identify a threshold of 90% debt-to-GDP as the trigger to a debt crisis. As shown in Figure 2, below, the U.S. has already passed that threshold.
Source: The White House: Office of Management and Budget (OMB) and Sprott Calculations
The historical evidence shows that:
- countries with large governments and high levels of debt have on average, achieved lower economic growth.
- Given the already high level of debt and deficits in most developed countries, it is doubtful that increased fiscal stimulus will really help the recovery.
- It’s clear that debt is the problem and the solution does not lie in piling on even more of it.
- The current debt situation, coupled with the increasing lack of transparency of politically motivated regulations and interventions, leaves little room for a healthy deleveraging of our economies.
Here is what central planners have in mind.
Debt overhang resolution and implications for the future
Througout history, high debt-to-GDP ratios have been resolved through five channels:
- Economic growth
- Sudden bursts of inflation
- Steady financial repression and inflation
#1 and #2 (Economic Growth and Austerity) are not working right now and, in some European countries, are actually negatively reinforcing each other. The U.S. is facing its homegrown fiscal cliff and political polarization makes its resolution doubtful.
#3 (Defaults) seems politically unacceptable for rich, developed nations, which see default as the realm of developing countries.
#4 (Sudden bursts of inflation) are hard to contain and work only so many times as investors, assuming a normal bond market, demand higher interest rates to compensate for inflation risk.
#5 (Steady financial repression and inflation) seems to be all that we are left with given interest rates already being at zero.
The term “financial repression” was first introduced in the early 1970s by Edward Shaw and Ronald McKinnon, both from Stanford University who define financial repression as:
- Explicit or indirect caps or ceilings on interest rates
- The creation and maintenance of a captive domestic audience (i.e.: forced holdings of government debt by financial institutions and pension funds)
- Direct ownership of financial institutions and/or entry restriction in the financial industry (i.e.: China, India)
We are clearly living through a period of financial repression. The symptoms include:
- Artificially low interest rates in most of the G20 countries and commitments to keep them low for long periods of time combined with inflation, which results in negative real interest rates
- Large expansion of central banks’ balance sheets through the purchase of government bonds
- Basel III liquidity rules which force banks to hold more government debt on their balance sheets
- Newly nationalized banks in many countries (UK, Ireland, Spain, etc.), which have drastically increased their holdings of government debt
- and it will only get worse…
Figure 3 below shows that financial repression can be observed within the holdings of U.S. financial institutions and pension funds, which have steadily increased their holdings of U.S. Treasuries since 2009.
FIGURE 3: HOLDINGS OF U.S. TREASURY SECURITIES BY DOMESTIC FINANCIAL INSTITUTIONS
Source: Federal Reserve Flow of Funds
It’s clear that governments are preparing for more.
A key component to erasing government debt through inflation is extending the duration (maturity) of one’s outstanding bonds. In a normal bond market, negative real interest rates make it difficult to roll over short-term debt at low borrowing rates (although financial repression and captive financial institutions certainly help to keep rates lower than they normally would be). Due to this tendency for short-term rates to rise with inflation, however, it is in the best interests of highly-indebted countries to issue the majority of their bonds at the long end of the yield curve.
As Figure 4 shows below,
- the US Treasury is proactively planning to increase the maturity of its outstanding debt (green line) in order to maximize its benefit from inflation erosion. In other words, they are capitalizing on the current flight to safety to set the stage for further financial repression down the road.
The same is true for the U.K., which benefits from one of the longest weighted-average maturity of debt in the developed world. For Eurozone countries to do away with their current debt overhang they will either have to:
- default (the least preferred option for political reasons) or
- use the good old combination of steady inflation and financial repression (feared by the Germans and the ECB central planners).
FIGURE 4: U.S. TREASURY WEIGHTED AVERAGE MATURITY OF MARKETABLE DEBT
Source: U.S. Treasury Office of Debt Management, Fiscal Year 2012 Q1 Report
On both sides of the Atlantic, the largest contributors to the current crisis are excessive debt and spending. We are now at a point where additional government stimulus measures will have negligible, if not detrimental effects on the economy and long-term growth. Debt has to be reduced, not increased by more deficits.
Central planners have demonstrated that they don’t have the discipline to implement the Keynesian model of surplus in good times in order to finance deficits in bad times. We have now reached the limit of indebtedness and need to muddle through a painful but necessary deleveraging.
The politically favoured option of financial repression and negative real interest rates has important implications.
- Negative real interest rates are basically a thinly disguised tax on savers and a subsidy to profligate borrowers. By definition, taxes distort incentives and, as discussed earlier, discourage savings.
- Also, financial institutions, which are traditionally supposed to funnel savings towards productive investments, are restrained from doing so because a large share of their balance sheets is encumbered by government securities.
- The same is true for pension funds, which instead of holding corporate paper or shares, now hold an ever growing share of public debt. Pensioners, who are also savers, get hurt in the process.
The current misconception that our economic salvation lies with more stimulus is both treacherous and self-defeating. As long as we continue down this path, the “solution” will continue to be the problem. There is no miracle cure to our current woes and recent proposals by central planners risk worsening the economic outlook for decades to come.
Editor’s Note: The above post may have been edited ([ ]), abridged (…), and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.
*http://www.sprott.com/markets-at-a-glance/the-solution%E2%80%A6is-the-problem,-part-ii/ (To access the above article please copy the URL and paste it into your browser.)
One of the things that’s being lost in the welter of rhetoric around the debt crises of sovereign nations is that these are not normal debtors, and government debt is not the same as personal debt. If you or I are in debt we are obliged to fulfil the terms of our repayment obligations or to go bankrupt or to pretend to die and go off and live on the life insurance. A country in the same situation has a range of other measures available to it…[Let’s explore their options and what their implications would be for the country and its citizens.] Words: 1145
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