Reality Bites

Events of the past few weeks are hardly surprising, though what has surprised is how long it has taken markets to cotton on to the underlying weakness of many of the (ironically misnomered) “rich world” economies, their government finances and their financial systems. We are now officially entering 'Phase III' of what was originally called 'the Credit Crunch'. Phase I was the 'Credit Crunch' which morphed in to the 'Global Financial Crisis'. Phase II was the phenomenally large and unprecedented policy response - budget deficits to 10% of GDP across the "rich" world, interest rates to zero and below through QE. And now, we have Phase III where reality bites. Policymakers have emptied their armouries, bar some potential for further QE. I'm sure they'll try to be inventive to try and maintain the unsustainable system that we have built up over the past 30 years, but at a certain point even Governments and policymakers cannot hold the flood bearing down on them.

A few thoughts on some interesting questions:

Question 1: Does the US deserve a downgrade?
Answer: Yes. Any country that collects 15% of GDP in tax revenue and spends 25% is going to start struggling pretty quickly, unless it rapidly changes course. And with the US political system as it is, changing course is hardly a given. Particularly when the changing course involves spending less or taxing more. Turkeys do not tend to vote for Christmas.

Question 2: Is the Eurozone sustainable in its current form?
Answer: Highly unlikely, unless the Germans want to pay for the Greeks to retire at the age of 55 forever more. Even if haircuts are taken on periphery debts, the problem will come back. The periphery is uncompetitive. Historically it only maintained its competitiveness through devaluations. Without those, the future is horribly bleak. At best one is looking at periodic crises (if haircuts are taken) and at worst that some members will leave the club. Not that that is a bad option, but it is just a tough one logistically. If I were in the Bundesbank I'd be thinking pretty hard about how to do that right now.

Question 3: Is Vince Cable right about the Banks needing to lend more?
Answer: Vince has obviously not read Richard Koo's excellent book 'The holy grail of macroeconomics'. I can't recommend it highly enough. It is about Japan's experience over the past twenty years and what a deleveraging really means. What Vince would learn is that the problem is not one of supply, but one of demand. Which businesses, in this environment, wish to take on more leverage? Not many. But either way, given that RBS and Lloyd's still have public shareholders, I personally think it rather inappropriate that he should be dictating their actions. They should be serving all shareholders, not just the majority one. I find it unfathomable that public shareholders have put up with his utterances.

And while I'm on Vince, not that I have a particular axe to grind, but he seems to be calling for more QE. While this may or may not be the right action, I would like to point out that the Bank of England is meant to be independent. As a member of the Government it is totally inappropriate for him to be calling for this action. I happen to think that the Bank will end up undertaking further QE, but it won't help their argument that they are independent (not that they ever really could be anyway due to the interdependence of fiscal and monetary policy). And with inflation high it will of course be contrary to their inflation-target.

But then, who said the target was important?!