Stumbling about in the dark

Stumbling about in the dark

As the world’s biggest economies continue to grapple with unprecedented economic conditions, John Gilbert, chief investment officer, GR-NEAM, examines the consequences of this and whether there is light at the end of the tunnel.

“May you live in interesting times”, it was said, because it is more sensible to wish it on somebody else, than to choose it for oneself. We are all the objects of unprecedented experiments in applied economics and finance, run by central authorities who, frankly, have no idea how they are going to turn out. 

Central banks in advanced countries are front and centre with their massive bond-buying programmes, while roaring along in parallel are the debt loads of the respective treasuries. In the US the issue of deficit control is actually beginning to permeate political action, rather than just debate. Unhappily, it is a fraught undertaking that is going to last for a very long time. Unfortunate also is the fact that the stakes may play out only in the very long term. The longer large deficits go on, the faster debt loads compound, and the greater the stakes become over time.

As the politics grind away in the US, interesting experiments are playing out elsewhere. The most interesting place is Japan, so for comparative purposes we will contrast three approaches:

The US, which seems unable to articulate any fiscal strategy at all;

The UK, with a reasonably clear strategy of austerity, at least for now; and

Japan, which recently voted for more of what has already got them into trouble.

As economist Herb Stein said, “If something cannot go on forever, it won’t.” But forever is an extremely long time, so perhaps one should let the years pass and, well, just see what happens. This is the Japanese strategy. Japan is a laboratory for one of the big experiments in big spending and big debt. It had its seminal economic smash two decades ago, and thus is ahead of other developed countries in accumulating the consequences over 20 years instead of just four.

The recent numbers are impressive. Table 1 shows selected deficits for the principal experimenters. First are the actual deficits as a percentage of gross domestic product (GDP). Included also are the cyclically adjusted deficits, which are calculated on the assumption that the respective economies operate at their potentials, which in many cases are well above where they are actually operating. The size of the cyclically adjusted deficits is a measure of the distance governments have to go to reach even some approximation of fiscal rectitude.

Table 1: Deficits as a percentage of GDP







Sources: IMF and GR-NEAM 


For perspective, the overall deficit for Spain in 2012 was 6.0 percent. Spain may yet require a bailout. The US, UK and Japan borrow in their own currency, however, and that makes all the difference. In the short term, it is a good thing; the long term remains to be seen.

Perhaps improbably, by electing Shinzo Abe’s LDP party to leadership Japan recently chose to spend more. The idea, of course, is to give the economy a shove. Whether this is more than a palliative measure remains to be seen. Coupled with currency devaluations, growth may improve, but how much is unknown in a country with a large aging population.

“If Japan were ever to come under financial market attack for its fiscal situation, the yen would probably be falling, and those reserves could be released.”






Chart 1: Debt as a percentage of GDP






*Sources IMF and GR-NEAM

The real story in Japan is 20 years of debt accumulation. Chart 1 shows debt levels for our three protagonists.

We should spend a moment on the subject of the differences between gross and net debt. It is a dreary one, but it does matter. Many Americans take comfort in the smaller net debt ratio. If you are among them, stop now. The largest difference between gross and net for the US is Social Security Trust Funds, which are accumulating the excess of payroll taxes over current retirement benefits. The aging of the population will cause that to reverse in time without major changes to benefits. The likelihood that such changes occur soon enough to cause the trust funds to become an asset for the government is essentially zero.

In Japan, on the other hand, a significant difference between gross and net debt is the government’s holdings of foreign exchange, accumulated over time in restraining the yen’s appreciation. Those holdings could in fact be used to reduce government debt, if the government were willing to allow the yen to appreciate. While that is unlikely in current circumstances, if Japan were ever to come under financial market attack for its fiscal situation, the yen would probably be falling, and those reserves could be released.

In judging the threat from debt loads, it is necessary to account for such differences. In most cases the correct treatment is to consider gross debt as the defining number, including in the US. Harvard economists Carmen Reinhart and Kenneth Rogoff have done in their work on the subject, as have other researchers. In certain cases, however, it is sensible to consider net debt. The IMF uses gross debt in measuring the fiscal adjustments required to achieve lower debt targets, except for Japan (together with Australia, Canada and New Zealand) for whom they use net debt.

What is not in question is that at least some of these debt loads are excessive. Considerable effort is underway to judge the long-term effects of high debt levels, particularly at the government level. Some governments, such as the UK’s, are attempting to act prophylactically in enacting austerity measures. The result is poor economic performance and political cost, on the bet that it works. It is not a certain bet.

Chart 2: IMF forecast of deficits






*Sources IMF and GR-NEAM

The IMF is relatively optimistic that it will work, and reduce the UK’s borrowing (Chart 2). For now, however, its performance is not much different from that of the US.

Such austerity as the UK is implementing appears to have a difficult assignment. Austerity in advanced countries since 2008 was more contractionary than expected. This is because interest rates effectively at zero reduce effectiveness of central banks, and because household consumption and business investment are both less likely to compensate for reduced government spending when the economy is operating so far below potential. 

There is another source of economic drag under such circumstances. This has been referred to as ‘fiscal sentiment’—the suggestion that taxes will be raised causes businesses to invest less and hire fewer people than they would in a fundamentally healthy economy in a typical cyclical recession. The Federal Reserve Bank of Dallas found that such a change in behaviour could account for more than half of the weaker than expected recovery since the bottom of the contraction. 

Much of the work on the fiscal sentiment idea, or the expectation of rising taxes, anticipated the fiscal debate in the US at the turn of the year. In this respect it is perhaps not helpful that, as soon as the ink was dry on the increase in the top marginal income tax rate, President Obama immediately asserted that it would not be the last. There is no better formula for sending fiscal sentiment from bad to worse. With such policies, rapid growth as in past recoveries remains elusive, even with the passage of four years. 

 Originally published by GR-NEAM in February 2013.

This is not an offer to conduct business in any jurisdiction in which General Re-New England Asset Management, Inc and its subsidiaries are not registered or authorised to conduct business. 

GR-NEAM, John Gilbert, Chief Investment Officer, Economic Conditions

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