Deaf
frogs, markets and credit
ratings By Chan Akya
"I don't have to outrun the bear;
I just have to outrun you."
That
old joke about two guys seeing a bear from the
distance, and one putting on some lovely running
shoes from his backpack; the other one asks - what
are you doing mate, you can't outrun the bear just
because of those fancy new shoes. That's when the
first guy replies as above.
This is
somehow appropriate for the sovereign debt markets
over the course of 2012. Many moons ago, I wrote
an article - "Deaf
frogs and the Pied Piper" (Asia Times Online,
September 30, 2008) - that was mainly about the
wrong lessons being absorbed by Asian policymakers
as they saw the global financial crisis
unfold, specifically taking
active positions against the free market. In the
event, Asian central bankers have continued to
intervene in the bond markets in an attempt to
keep their currencies "competitive" and in effect
create a whole bunch of second-order effects in
global debt markets.
Of course, in
addition to the actions of Asian central banks,
efforts by the Financial Times' "Man of the Year"
(I called him that first, back in January this
year) European Central Bank president Mario Draghi
in pumping out hundreds of billions of euros, and
"Helicopter" Ben Bernanke, who as chairman of the
Federal Reserve has gone from QE1 and QE2 to QE3
and now either QE3.5 or QE4.0 depending on who you
believe, have resulted in a flood of liquidity
that has lifted pretty much all boats in the
sovereign debt market.
Even the ones with
holes mind you; so quick has been the tide that
even these horrible pieces of rotten wood have
managed to stay afloat long enough to fool anyone
into thinking they were actually viable boats.
This is of course where the financial
media and Keynesians come into the picture - if
one bothers to make any distinction between the
two that is. The three notes below [1-3] show:
a. An article on the Bloomberg website that
dismisses the effects of rating downgrades on
sovereign debt markets this year; b. An article
in the Financial Times that does the same, in the
more narrow context of France; and c. An
article by Paul Krugman about the US not having a
debt crisis.
I could get snarky and ask
whether Krugman is having an identity crisis
between his roles as a polemicist or an economist,
but that would be too churlish for this time of
the year. Instead, let's look at the basic aspects
of the global bond markets; facts that are more or
less undisputed: 1. Most of the top benchmarks
now trade through their own inflation rates, ie
investors have accepted negative real yields over
the course of this year; 2. Most of the Group
of Seven/Organization for Economic Cooperation and
Development (OECD) is still saddled with excessive
debts compared to the demographic and economic
realities of today; 3. No country other than
Ireland and Germany has initiated let alone
succeeded in quelling yawning budget deficits over
the course of 2012; 4. Many more countries are
likely to be downgraded in the OECD than upgraded
over the next five years based on current trends
in fiscal deficits and any (extraneous or even
expected) shock to interest payments; 5. Banks
haven't been fixed globally, and the cost to do so
- much of it to be absorbed by governments rather
than free markets - still numbers in the hundreds
of billions in terms of new capital and write-offs
of bad assets currently on the books; 6. There
is the US fiscal cliff, which looks set to be
resolved albeit with the type of compromise that
may actually sink US credit ratings over the near
term; 7. Japan's newly elected LDP government
is looking to sell more sovereign debt to the Bank
of Japan, even as it forces private savers to join
with the government in buying foreign debt in a
bid to keep the yuan weaker; this will cause a
significant credit downgrade in 2013-14; 8.
Then there is the grandfather of all crises, the
European sovereign debt crisis; wherein Greece
avoided being ejected from the common currency
zone in 2012 but faces the same pressures once
again in 2013. Spain and Italy are likely to hit
the wall once again too, and elections for a new
German chancellor may change the direction of the
debt crisis inexorably towards a breakup of the
union
So if all these issues are likely to
buffet the sovereign debt markets, why then are
yields so phlegmatic? Quite simply because of the
central banks: as they attempt to apply the
lessons of classical economics, risks of a
different type of crisis are building up. In a new
paper by the Bank of International Settlements,
Claudio Borio writes eloquently on the subject of
macroeconomics in general and monetary (policy)
economics in particular and how policy makers are
absolutely failing to grasp the risks of their
actions. He summarizes the essay thus:
Three themes run through the essay.
Think medium term! The financial cycle is much
longer than the traditional business cycle.
Think monetary! Modelling the financial cycle
correctly, rather than simply mimicking some of
its features superficially, requires recognising
fully the fundamental monetary nature of our
economies: the financial system does not just
allocate, but also generates, purchasing power,
and has very much a life of its own. Think
global! The global economy, with its financial,
product and input markets, is highly integrated.
Understanding economic developments and the
challenges they pose calls for a top-down and
holistic perspective - one in which financial
cycles interact, at times proceeding in sync, at
others proceeding at different speeds and in
different phases across the globe.
[4]
Reading through this carefully, it
is clear that the author doesn't expect currency
monetary policy actions to produce anything other
than a long-lasting adverse reaction in the
underlying economies. Specifically, the article
addresses the resurgent strain of Keynesian idiocy
in terms of expansionary fiscal policy:
Consider fiscal policy next. The
challenge here is to use the typically scarce
fiscal space effectively, so as to avoid the
risk of a sovereign crisis. A widespread view
among macroeconomists is that expansionary
fiscal policy through pump-priming (increases in
expenditures and reductions in taxes) is
comparatively more effective when the economy is
weak. Economic agents are "finance-constrained",
unable to borrow as much as they would like in
order to spend: their propensity to spend any
additional income they receive is high (eg, Gali
et al (2007), Roeger and in 't Veld (2009),
Eggertsson and Krugman (2012)). In addition,
with slack in the economy and interest rates
possibly already constrained by the zero lower
bound, there is no incentive to tighten monetary
policy in response (eg, Eggertsson and Woodford
(2003), Christiano et al (2011)).
This
view, however, does not seem to take into
account the specific features of a balance sheet
recession. If agents are overindebted, they
may naturally give priority to the repayment of
debt and not spend the additional income: in the
extreme, the marginal propensity to consume
would be zero. Moreover, if the banking
system is not working smoothly in the
background, it can actually dampen the
second-round effects of the fiscal multiplier:
the funds need to go to those more willing to
spend, but may not get there.
Importantly, the available empirical
evidence that finds higher fiscal multipliers
when the economy is weak does not condition on
the type of recession (eg, IMF (2010)). And some
preliminary new research that controls for such
differences actually finds that fiscal policy is
less effective than in normal recessions (see
below). This is clearly an area that deserves
further study.
The highlighted
section has very much been the experience over the
past few years of Keynesian idiocy. Today, the
stock of excess cash in customer accounts across
the US banking accounts is US$2 trillion [5], well
over the threshold in 2007 due mainly to an
increasing, marginal, propensity to save rather
than consume. Monetary policy in the US has
failed, in other words, because it has produced
the exact opposite to expansionary fiscal policy
(this can also be written in the opposite sense ie
that fiscal expansionary policy has failed...).
It is thus important at this stage to step
back and ask the question - what are the billions
of dollars in US bank savings and those of Asian
central banks doing now? Or more importantly,
where are they invested now: and therein lies the
answer to the question asked at the beginning of
this article about credit quality. This money
in bank accounts (commercial in the US and central
in Asia) is not available for classical risk
investing: US banks aren't lending, and Asian
central banks don't understand risk anyway. So the
money is parked in government bonds around the
world, in effect pushing down yields of the
undeserving borrowers because there is, quite
simply, nothing else to do with the money. An
observation of this type produces an equal and
opposite corollary: what then? Where we are headed
is a special branch of investment economics that
classifies success as the equivalent of failure.
No comprendo?
Well, all it means is that,
at the first sign of success, ie economic growth
arising from "animal spirits", investors will have
to comprehensively dump sovereign bonds; however,
the dumping will push up yields and therefore
destroy any nascent recovery. As an opposing
force, any economic failure, viz a "dip" to
recession, will increase the holdings of
government bonds and effectively push yields even
lower when credit quality is arguably at its
worst.
These contrarian forces will work
through the markets across currency, time and
economic zones. Sometimes Japan will be down, and
at other times it will be Germany. An alternative
to such a volatile existence could be simply dump
all government bonds from one's portfolio, buy a
heck of a lot of gold and wait on the sidelines
for positive economic growth indicators.
And in passing, a joke about investor
choices in sovereign debt markets expressed on a
more human note; in this example I will simply
state investors are the "old man" and governments
their "wife":
There was a man who had
four children, all extremely good-looking, except
for the youngest one, Craig. Craig was quite ugly!
The man grew old, and just before he died he asked
his wife, "Mary, I have only one question. Please
tell me the truth. Am I Craig's father?" "Yes,
my dear," replied his wife. "I promise you, Craig
is 100% yours." The husband smiled. "I can die
a happy man. Goodbye, my love." And he peacefully
passed away. Mary gave a big sigh and said,
"Thank goodness he didn't ask me about the other
three." Best regards for the holidays folks,
and may you all have safe travels, happy tidings
and a merry time with kith and kin.
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