Recent market volatility reflects the growing tensions between perceptions of the short and long-term consequences of policies being pursued by monetary and economic authorities. I have consistently drawn attention to the dilemma posed by the deflationary or inflationary outcomes of the current crisis, making it clear that the latter is the lesser of two evils.
As time passes, we can observe that many of the economic indicators are consistent with historical patterns observed in previous cycles: the stock market troughs approximately 6 months prior to the 'formal' end of a recession, unemployment continues to increase during the early stages of the recovery and important productivity gains are achieved.
Contrary to a 'normal' cycle, these encouraging signs are, however, being tempered by warnings by the highest officials (the President of the United States, of the Federal Reserve Bank and their opposite numbers in most developed economies) that we are not yet, by any stretch of the imagination, out of the woods. Indeed, after the welcome 'jobs' report for November in the US which triggered immediately an anticipation of an accelerated implementation of 'exit' strategies, the Fed Chairman, Ben Bernanke, had to reassure markets that low interest rates would be maintained for the foreseeable future so as not to choke off the still very fragile recovery.
The reasons why the normal pattern of recovery should not be expected are easy to finger because, in the present case, it is not possible to rely mainly on the automatic stabilisers to restore public finances as the economy improves. Indeed, the crisis having been caused by excessive indebtedness accumulated over several decades, it is necessary to address the embedded structural causes of the crisis. This involves a significant deleveraging process so as to restore a sustainable balance between indebtedness and the value of corresponding assets (or future revenues) that it is supposed to 'partially' (pre)finance.
There is quasi-unanimous agreement that, in order to facilitate the recovery, it is too early to implement exit strategies through either monetary policy measures or by curtailing economic stimulus programmes. On the contrary, there are strong pressures for extending existing government support programmes (unemployment benefits, credit enhancement measures, job creation schemes etc.), all of which imply temporary additional government spending, widening budget deficits and consequently increased public indebtedness. On the monetary policy front, a prerequisite for withdrawing excessive liquidity from the system is the restoration of the health of the financial system which, if it appears less vulnerable to a global meltdown than a year ago, remains nevertheless in the early stages of convalescence.
It is worth reflecting on the implications of this situation: banks are being required to reduce simultaneously their 'risk' profile through a deleveraging process while strengthening their capital base. This is achieved by reducing the offer of credit, increasing lending spreads and raising fresh capital from the market.
- Reducing the offer of credit flies directly in the face of government efforts to stimulate lending, in particular, for the benefit of SME’s.
- Increasing lending spreads can be attributable to a combination of different factors:
o An improved pricing of risk compared with pre-crisis levels.
o The desire to increase profitability to restore the capital base.
o The deterioration of the solvency of borrowers due in part to the crisis itself. This trend is reinforced by the - welcome - reopening of the corporate debt market which allows the most creditworthy borrowers to take advantage of the low interest rate environment to reduce their dependency on bank financing but reduces the incentive banks have to lend.
- The raising of fresh capital from the market remains restricted to the strongest institutions and involves significant problems:
o The dilution of existing shareholders.
o The uncertain outlook for future profitability in the face of the outcome of regulatory reform including enhanced supervision.
o The considerable uncertainty surrounding the valuation of assets which puts into question the reliability of apparently satisfactory “Tier 1” capital ratios.
o Access to equity markets could be further impaired if any weakness in the Stock Market developed after the 6 month uninterrupted upward trend from last March.
The consequences of the foregoing are clear: it is difficult to envisage a strong improvement in the access to credit in the near future. Availability of credit to SMEs will remain reliant on continued government support measures. As soon as monetary authorities increase interest rates the costs will be fully passed on to borrowers: at present official base rates are at historic low levels which allow SMEs to finance at a reasonable 'absolute' cost despite high spreads but these would rapidly become unaffordable once the tightening cycle is initiated.
On the labour front, the moderate pace of the recovery should mean that job creation will remain muted. The deliberate acceleration of the process, as proposed by President Obama, to engage in a virtuous cycle of investment - employment – consumption – further growth – reduction in unemployment benefits – increase in tax revenues - reduction in budget deficits implies the temporary increase in deficit spending and further increases in government debt.
The temporary and appropriate continuation of stimulus measures coupled with accommodative monetary policy means that, during the months ahead, the aggregation of the imbedded structural indebtedness with the policy engineered cyclical deficits could reach a point where the credibility of a well controlled exit strategy is put more and more into question. It is generally accepted that a too rapid exit could lead to a deep depression while the prospect of prolonged accommodative policies risks to fuel inflationary expectations before a sustainable recovery is underway.
It is therefore of the utmost importance to move rapidly to the next stage of managing expectations concerning exit strategies and inflation as the British Chancellor of the Exchequer has courageously – if not entirely convincingly – attempted to do in his December 9th pre Budget Report to the House of Commons.
Several key ingredients need to be addressed:
- International solidarity in the implementation of exit strategies as well as financial reform;
- Equitable burden sharing in correcting the structural imbalances embedded in the national and international economies.
The current debate on taxing 'bank bonuses' offers a clear example of a worthy attempt to reach a specific international agreement but also underscores the difficulties of achieving a broad consensus. It is true that this particular topic may not have been ideal to initiate such a test of international solidarity as its selection is, in part, based on dubious populist (if not electoral) arguments aimed at appeasing a justifiably outraged public opinion. It provides therefore ample scope for well argued opposition on ideological (USA), legal (Germany) or technical grounds (Switzerland).
This does not bode well for the future coordination of exit measures and poses some very serious problems at the level of the Eurozone: indeed, in implementing exit strategies there must be close coordination in timing between monetary and budgetary measures; this is much easier to achieve in countries that have retained full sovereignty over their monetary affairs. In the Eurozone, however, unwelcome disruptions could occur if EMU Members did not ensure sufficient compatibility in the timing of their respective budgetary measures to complement the monetary policy measures decided by the ECB. There can be little doubt that the ECB will privilege achieving its statutory mandate of 'price stability over the medium term' if it is faced with rising inflationary expectations. The result could be a premature increase in interest rates that could penalise the recovery in those EMU Member States that would have followed sound budgetary practices relative to those who would indulge in excessive deficit spending and corresponding increases in debt financing that are causing inflationary expectations to increase.
Concerning financial reform, the European Council proposals provide another emblematic example of an intergovernmental consensus achieved at the level of the lowest common denominator. Though undeniably constituting progress as compared to the prevailing framework, its notorious lack of ambition needs to be thoroughly corrected by the European Parliament who must exercise to the fullest its new co-decision powers conferred by the Treaty of Lisbon. It is also regrettable that there is not more prior direct consultation between the EU and the USA who both are pursuing the enactment of sweeping reforms of their financial regulatory system. These might turn out to be less than coherent when presented to the G20 for translation into a much needed worldwide regulatory framework.
A specific area of regulatory reform, where international solidarity and coordination is needed, is the question of reducing moral hazard in dealing with the 'too big to fail' syndrome. The US Congress seems close to enacting legislation that will grant the Executive Branch the necessary Resolution Authority to deal with distressed systemically relevant firms in such a way as to wind them down while limiting the domino effects of counterparty risk as well as taxpayer liability.
What is particularly worrisome is that while the problem has been well identified as far as 'systemically important' financial operators, little attention is being paid to the “too big to fail” question relative to Sovereign borrowers. This is crucial because of the strong linkages between Sovereign borrowers and the strength of their respective national banking markets. One should remember that it was the rapid government intervention in October 2008 through bold measures, such as increasing amounts covered by deposit guarantee schemes and extending government guarantees to banks, that largely contributed to restoring public confidence in credit institutions. It follows that fears surrounding the solvency of a Sovereign borrower automatically contaminate its domestic banking market as is demonstrated by the immediate downgrade of Greece’s 4 largest banks in the aftermath of the lowering of the country’s sovereign rating.
It is well accepted that remedying past failures does not necessarily forestall a future crisis developing from totally different causes. The introduction of macroeconomic surveillance aims at creating a new powerful tool to better apprehend systemically harmful developments in a timely manner. In this regard the debate has largely focussed on the structure of the proposed Systemic Risk Councils, their independence, their respective executive or advisory powers, the coordination and sharing of information between the various participating Financial Regulators in particular Central Banks, as well as the definition of systemically important entities.
The most recent developments in financial markets point to the fact that most 'Sovereign borrowers' should undoubtedly be counted among “systemically important” entities. It appears however that, to date, despite the fact that the legislative process is well underway, the question of Sovereign borrowers has been totally ignored in the design of the proposed surveillance mechanisms both in the USA and the EU.
Though by no means discounting the political sensitivities involved, it would seem indispensable to take this latter dimension fully into consideration so as to be able to include the systemic implications of a Sovereign default. This will certainly involve giving the IMF a central role in this particular regard and thought should be given to having one of its staff represented on the future Boards of the Surveillance Councils. Failure to address this question will considerably weaken the effectiveness of the proposed reforms and leave a gaping hole in the surveillance mechanism.
This question is rapidly becoming acute and could easily become the trigger of a new crisis if left unaddressed, as clearly the resources to deal with a new major crisis are not available in the near term.
While the debt restructuring associated with some of the 'private sector' operators in Dubai may be manageable if it remains an isolated case, the origin of this problem lies with the (false) perception that these companies benefitted from an implicit government guarantee. This created a typical moral hazard environment leading to the considerable overextension of the indebtedness of the entities concerned. One should recall that in the previous case of such misguided perceptions, i.e. the debt of Fannie Mae and Freddie Mac, the US Government was compelled to assume overnight their debt because of the 'too big to fail' syndrome (6 trillion dollars) doubling at a stroke the total government debt of the United States. Their refusal to do so would have lead to a meltdown of the financial system even before the failure of Lehman Brothers.
Recent developments affecting countries including Greece, Portugal, Spain, Ireland -all members of the Eurozone – make it imperative to face up to this question. Indeed, it would appear inconceivable to tolerate the default of a Eurozone Member because the consequences would not only affect the Member in question but are likely to put the entire EMU construction in jeopardy. It is therefore quite understandable that Eurogroupe President, Jean-Claude Junker, has discarded out of hand the possibility of a Greek default and that ECB President Trichet is 'confident that the Greek Government would take necessary steps to restore public finances'.
It follows that it is necessary to align the credibility of such statements with existing Community legislation: in other words official recognition should be given to the fact that the (in) famous 'no bail out' clause contained in the EMU framework must be amended to dispel any misunderstandings. This is in the interests of all 16 EMU participants. In addition, serious thought should be given in introducing a mutualised EMU deposit guarantee scheme to forestall the contamination of the banking market in the aftermath of an unlikely sovereign default.
While of a different nature, a strong 'political' argument can be made that the EU should also underpin the solvency of non EMU members. Technically this is easier to implement because of the existence of the €50 billion “balance of payments” facility benefitting from an EU budget guarantee. Once again one can point out the common interest of all Member States to avoid the insolvency of one of its Members as the aura of the EU as a whole would be severely impaired if such a default occurred.
There must be significant conditionality attached to any Community intervention aimed at preventing the insolvency of a Member State. A pre-existing enforceable framework is a prerequisite for conferring to the mechanism the necessary credibility. However, setting up such a mechanism should prove far less costly and more efficient than reacting piecemeal to individual crisis. Its very existence should exert a strong moderating influence on markets by eliminating the temptation to 'test' the resilience of a particular borrower by forcing ever widening 'spreads' on its national debt compared with the benchmark.
Explaining to the citizen the 'truth' of this very precarious situation (as President Sarkosy and President Obama both promised recently in their respective Toulon and Allentown speeches) is of paramount importance. It is certainly not above the capacity of the average citizen to understand that international solidarity is the cheapest (and probably the only) way out of the crisis and creates the best foundation for defending narrow individual interests.
Furthermore, it is unavoidable that after the financial excesses of the past decades, there should be a steep price to pay for establishing future prosperity on a sound footing. It follows that, in order to manage appropriately inflation expectations, it is imperative to indicate very clearly that, as the recovery gains both momentum and sustainability, the restoration of budget equilibrium will necessarily entail significant increases in taxation.
Of course the burden must be shared equitably with the weakest being spared to the greatest extent possible. The fact that the overwhelming majority of citizens, whatever their economic status may be, are totally innocent from the commission of past mistakes does not, unfortunately, exempt them from sharing in the pain. In the name of national solidarity, a strong plea should be made to shelve temporarily the claims by those elements of society that are in a position to blackmail their fellow citizens in defence of their sectional interests through their nuisance capacity.
As far as the European Union is concerned, I had already suggested earlier on in the crisis the 'utopian' view that the financial crisis created a unique opportunity for rapidly extending the Eurozone to all Member States. Recent developments, which have been alluded to here above, make this suggestion ever more relevant: indeed, at the present time practically all Eurozone Members are in breach of the Maastricht criteria and are subject to 'excessive deficits' procedures. It appears therefore hardly credible to subject future candidates to tougher standards than those being met currently by EMU Members. Accepting more flexibility in the criteria for joining EMU has numerous advantages:
- The cost to existing EMU Members should prove very likely to be considerably lower than supporting financially non Members to weather the crisis (see points on EU solidarity here above).
- The size of the economies of new entrants is collectively manageable and should create less disruption than the earlier integration of East Germany into the EU.
- Should such a move entail a “weakening” of the € relative to the US dollar and Asian currencies, this can be judged as a particularly positive development within the present context. It constitutes an appropriate policy response to counter the detrimental effects on EU competitivity resulting from the pegging of Asian/Gulf currencies to the USD and that are currently being endured in a purely passive mode.
- The extension of the single currency zone (leaving possibly the United Kingdom aside at its own risk and perils) would further insulate the Eurozone economy from world markets as some 90% of trade would be carried out within the enlarged internal currency area.
- The current external balance of the EU is close to equilibrium, (as opposed to the structural deficit position of the United States), so that the Eurozone should not be constrained by considerations concerning the funding of its external deficits in implementing its internal economic policies. The Eurozone could therefore reap the advantages of being able to consider the external value of its currency with “benign neglect”.
- The negotiating position of the EU would be materially reinforced on the world stage, particularly in speaking with a single stronger voice in the areas of trade policy and financial reform.
- A revised and substantially more flexible Stability and Growth Pact could be instituted (if not entirely eliminated) if a sufficiently integrated economic policy framework was devised. One should remember that Japan has been able to sustain a huge government debt to GDP ratio (300%) while simultaneously fighting deflation. A quid pro quo between pooling some economic sovereignty against greater flexibility in managing indebtedness could prove an attractive way out of the current constraints imposed by the SGP, particularly to some of the largest EMU Members such as Italy, France or Spain.
- A substantially more ambitious and effective European regulatory framework could be designed including a single regulator that would complement appropriately the common monetary policy.
Such a line of thought may still be in the realm of utopia; however it could have greater appeal today as the costs of pursuing independent economic policies in a globalised economy become clearer to many of the weakest and strongest EU Members alike.
A lot of praise has been given deservedly to both Governments and Monetary Authorities for the decisive way in which they intervened to forestall the implosion of the financial system avoiding its disastrous economic and social consequences. Credit should also be given for seizing the nettle of financial reform, though the jury is still out as to whether the political will is strong enough to push through effective and meaningful measures.
While attempting not to be alarmist, the reflexions in this paper are aimed at giving some substance to the declarations of the highest political and monetary authorities that emphasize that, despite encouraging signs, the world is still far from having overcome the deepest economic and financial crisis since the 1930’s. It also should serve as a signal for stepping up considerably the communication on exit strategies outlining as transparently as possible the hard realities that lie ahead. President Obama underlined this point in his Allentown speech when he stated his intention to do the right thing by his country rather than to worry about re-election. With a little luck he will be successful in both these endeavours and Member States of the EU should follow suit.
© Paul Goldschmidt