Tuesday, August 2, 2011

Debts, Deficits, Ratings, and Nonsense

A sense of economic gloom has spread across the world. There are now beginning to be indications of economic panic. The US debt limit non-crisis is now out of the way so people can spend full-time worrying about the credit-rating-downgrade crisis. The eurozone debt crisis seems to have no end in sight as more and bigger economies become threatened with higher debt costs. On a slow news day on those fronts one can choose between worrying about China, India, or the ever popular Japan. One writes about the relatively healthy countries in the context of what could go wrong, and when. Are things really so intrinsically bad—or are nations causing themselves grief by poor policy decisions and by following nonsensical economic advice?

Most of the developed world is still emerging from the “Great Recession,” the worst financial crisis since the Great Depression. Is it any wonder that government debt has had to increase in order to compensate? The Economist provided an article discussing the deleveraging of debt, both public and private, that they see as inevitable. This interesting chart of the structural debt of four countries was provided.

The data was provided by McKinsey Global Institute which contributed this insight into the future.

“In a study early last year, the McKinsey Global Institute, the consultancy’s research arm, noted that combined public and private debt burdens had reached historic highs in many rich countries. Based on previous episodes of debt reduction, it reckoned that once deleveraging began, countries would on average spend the next six to seven years whittling those debt ratios back by around 25%.”

Deleveraging entails taking money out of the economy. Even McKenzie recognizes that this leads to economic contraction. And what is the surest source of public and private debt growth? Economic contraction, of course. So why is everyone dead set on reducing debt at the expense of growth right now instead of waiting for better times when growth can sustain debt reduction?

Looking at the chart above, who would appear to be the country with the worst debt issues? It wouldn’t be Spain. In terms of government debt burden one might conclude that Spain was the healthiest of the countries. Is there much difference in the debt burdens of the US and Germany? Germany is viewed as one of the healthiest economies and the US is facing a potential lowering of its credit rating. Yet, the US is actually lowering its structural debt, while Germany’s is increasing. One can argue that the US will not be able to raise its revenue sufficiently to contain debt growth, but that is pure speculation based on today’s politics. There is plenty of latitude in the context of a healthy economy to raise revenue and cut costs and easily cap the growing national debt. Germany is really in no better position. It has steadfastly refused to take the obvious path out of the eurozone crisis. It and other countries could have bought up enough of Greece’s bad debt and limited what now has become an EU-wide problem. Instead the decision was made to lend money, guaranteeing a crisis with no end in sight. People just haven’t had time to speculate on Germany’s future yet.

What Spain and the US have are growth issues rather than debt issues, yet this is the advice they are given:

“In June the IMF urged America to slash its structural deficit by a cumulative 7.5% of GDP by 2016, enough to trim 0.5-0.75 percentage points off average growth over the period.”

This emphasis on debt/deficit reduction has the scent of mass hysteria about it. In another article, The Economist provides this data

“In a recent study of 173 fiscal-policy changes in rich countries from 1978 to 2009, economists from the IMF found that cutting a country’s budget deficit by 1% of GDP typically reduces real output by about two-thirds of a percentage point and raises the unemployment rate by one-third of a percentage point.”

So how does deficit reduction combined with low or negative growth become a good thing? Incredibly, there is a notion that lowering debt will instill confidence in those who hold the debt and who might be needed to purchase more. This assumes that bond holders and purchasers are as devoid of knowledge as the economists who conjured up this notion. It also assumes that by smiling confidently at a pack of jackals you can convince them to not attack.

There is no indication that the US will have any trouble acquiring new debt as required. Its bonds are needed and desired by nations as a source dollar-denominated assets for their foreign currency reserves. There are limits of course, but we don’t seem to be at one. Consider poor Greece. Most of its debt is held by banks in Germany and France. One could claim that the eurozone crisis occurred because these banks made dumb loans to countries that couldn’t afford them. So Europe, and perhaps the world, will have to suffer to protect these banks from the results of their stupidity. These are the same banks that contributed to the Great Recession by making dumb investments in US mortgage-backed securities.

The great villains in this economic tragedy are the credit rating agencies: S&P, Moody’s, and Fitch. The reason we are where we are is because the fools and knaves at these organizations kept telling institutions that financial constructs that were garbage were actually AAA. They must share the blame with those who created these mortgage-back disasters. They must also share the blame for failing to warn banks that lending more money to Greece was not a good idea. Now these same agencies believe they deserve to determine the fate of nations. Suddenly they have begun to suggest economic policy moves that would be required to maintain a credit rating. One would think that with their history of malfeasance they would be less arrogant. One can always hope that the current batch of fools and knaves is smarter than the last. One can also believe in the tooth fairy.

We have been discussing crises that only exist because they were created by bad financial decisions. Let’s go back to sound economic principles and try to grow our way out of them instead of trying to make them worse.

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