Paradox of Thrift - Sovereign Style

During a period of economic uncertainty, an individual who chooses to cut spending and increase savings would be deemed prudent. However, when tens of millions of individuals collectively make the same prudent choice, it becomes more difficult for each individual to save more, if everyone else spends less. And therein lies the paradox of thrift. As the financial crisis intensified in late 2008, millions of Americans became reformed spendthrifts. Within a few months, the national savings rate jumped from under 2% to almost 6%, and the U.S. economy tanked as consumer demand for goods and services evaporated. The government stepped into the breach by shoring up the banking system, and spending billions to prop up demand. The government extended unemployment benefits from 26 weeks to 99 weeks, to more than 8 million workers who had lost their job. This helped those affected directly, and also propped up the economy. The safety net of unemployment benefits, food stamps, Medicare, and Medicaid has led most economists to believe that another depression would not be possible, since consumer demand would be supported by the myriad of safety net programs. The law of unintended consequences is often at work under the best of circumstances, but more so when the government is involved. My take on the government's safety net programs has therefore been a bit different. Wouldn't it be ironic if the safety nets actually contributed to the next depression?

When discussing the circumstances that could lead to the next depression with a good friend of mine back in the mid 1980's, my thoughts ran along these lines. If the U.S. economy experienced a deep recession, the budget deficit would explode as all the safety net programs kicked in. Initially, they would help soften the depth of the recession. The Federal Reserve would also dramatically cut short term rates. But if a confluence of events caused the recession or period of slow growth to be prolonged, and low rates didn't revive the economy within a reasonable period, monetary policy would effectively be emasculated. The continuation of expensive safety net programs and weak tax receipts would result in chronically high budget deficits. Sooner or later, the bond market might begin to choke on the torrent of paper, and long term interest rates could begin to move higher. Although the Federal Reserve might try to buy bonds, I didn't think that strategy would work over the long haul. I also dismissed the Fed's choosing to inflate our way out of debt deflation, since bond market participants aren't stupid. Any real evidence that the Fed was even contemplating the inflation route would cause interest rates to potentially soar, which would cripple the economy faster than you can say Mickey Mouse.

Back in the mid 1980's, this analysis was totally theoretical, and the U.S. was just coming down from a huge bout of inflation. The economy had emerged from the deep 1982 recession, and was growing nicely. The 20‐year Treasury bond was yielding almost 11% and the Federal funds rate was 8.5%. Today, this mid 1980's theoretical analysis is the reality we are facing. The primary difference is that this analysis does not just apply to the U.S., but to every developed country in the world. Most of the developed countries reacted to the financial crisis, by increasing their respective budget deficits to unprecedented levels. The annual national deficits of the 30 members of the Organization for Economic Cooperation and Development have grown almost sevenfold since 2007 to $3.4 trillion. The total debt burden for these 30 countries has increased to a record setting $43 trillion. For the 16 countries in the Euro zone, the deterioration has been worse. Annual national debts have soared by $7.7 trillion, more than 11 times their 2007 levels.

According to the International Monetary Fund (IMF), and based on GDP estimates for 2010, the total debt to GDP ratio for Greece is 124.1%, Italy 118.6%, Portugal is 85.9%, Ireland 78.8%, and Spain's is 66.9%. The U.S's debt is 92.6% based on 2010 GDP, and that does not include the debt guarantees for Fannie Mae and Freddie Mac. The chart above is based on data compiled by Euorstat for 2009, and the Congressional Budget Office for the U.S. Although the statistics are slightly different, the story and message are the same.

The fiscal policy responses by governments around the world that were required to stabilize the global economy and financial system must now be unwound gracefully. And that's not going to be easy to pull off in a global interconnected world that trades in microseconds. In medieval times, a gauntlet was a form of punishment or torture in which people armed with sticks or other weapons arranged themselves in two lines facing each other and beat the person forced to run between them. In coming years, the global bond market will represent a Sovereign Debtor's Gauntlet. We are about to witness the Paradox of Thrift being applied on the sovereign government level. I suspect most governments will take the threat from the global bond market seriously, and so most will present a reasonable deficit reduction plan.

Over the next three to five years, the U.S., Britain, Japan, Germany, France, Italy, Spain, and most of the other countries in the E.U. will have to present credible plans to reduce their budget deficit to near 3% of GDP. A few fortunate countries will only have to slow the rate of growth in public spending, and increase taxes modestly to lower their budget deficit to GDP ratio to below 4%. The U.S., Britain, Japan, Germany, France, Italy, and Spain won't have it so easy, and will have to slow spending growth significantly. But most of the heavy lifting to narrow sovereign budget deficits will come from higher taxes. Any serious effort in the U.S. will wait until after the November election. No one wants to run on the "We're raising your taxes, and cutting services too!" slogan. Just as George W. Bush reneged on his pledge "Read my lips: No new taxes." President Obama will be forced to raise taxes on most of the 95% he said he wouldn't. He will have plenty of company, and misery does love company, as governments around the world are forced to hike taxes on the rich and middle class. Politicians have no choice but to tell most workers the truth ‐your taxes are going up. This news won't endure politicians to voters in any country. Less disposable income will make it harder for consumers to save more, especially when their disposable (after tax) income is shrinking due to more taxes. In the United States, many baby boomers were expecting and counting on their home value to fund a nice chunk of their retirement, after it was sold. Now, they've got to spend less and save more, which isn't as much fun as shopping. They're not in a good mood, and in the next few years, a rising tide of taxes will find them recalling the good old days of 2010.

The combination of less sovereign government spending and higher taxes will curb economic growth, and result in an unintentional coordinated global slowdown that should kick in within a year. The paradox will be that each country is acting in its own best interest! At a minimum, most developed countries, which comprise more than 60% of global GDP, will see 1.0% to 1.5% shaved off their annual GDP growth. As Greece implements the fiscal restraint imposed by the IMF, Greece's economy is expected to shrink by at least 5%, over the next year or so. Slower economic growth will hinder job creation, which won't reduce the ranks of the unemployed quick enough. Long term mass unemployment is the Witches Brew of discontent and revolution. As governments are forced to reduce aid to people who depend on their governments' support to live, governments risk an escalation of frustration, anger, and if left to simmer long enough, outrage that explodes in the type of violence seen in Greece. This is not a good time to be a politician.

Very simply: We are entering a period of unpredictable rapid change that could last another 3 to 6 years, and possibly longer.

Longer term the outlook for many developed countries is even more challenging, since the gap between the ‘official' figures and a more realistic estimate of the unfunded liabilities is huge for a number of countries. The orange bars show the official debt figures as a percent of GDP. The grey bars include the total amount of unfunded liabilities for social security, pensions, and health care programs like Medicare in the U.S. Spain's total is 250% of GDP, while Germany and Britain are near 400%, as is the average for the E.U. The United States and France clock in at 500%, while Greece is 800%. This means the U.S. has unfunded liabilities of $70 trillion, while it advertises an official level of debt of ‘only' $12 trillion. Sooner or later, someone is going to tell the American people what should have been obvious to everyone long ago, had they been paying attention to something other than sports, shopping, Lost, and American Idol. There is no way the U.S. government will ever be able to make good on its promises, since it can't raise enough in taxes to avoid a serious reduction in promised benefits. It is one thing to make jokes about the viability of social security when retirement is years away. But it is entirely different when confronted with the stark reality of cuts in benefits and an extension in the retirement age for the millions of Baby Boomers on the cusp of their Golden Years.

In terms of growth, China, India, Brazil, South Korea, and a number of smaller Far East countries lead the pack with growth rates far above the developed countries. As I have discussed since December, the central banks in these countries are facing very different challenges than those facing the central banks in developed countries. The primary risk in the developed countries is deflation. In India, China, and Brazil, the greater risk comes from inflation. As I have noted in prior letters, interest rates are already being raised in these higher growth countries to slow their economy's growth so inflation is tempered, and in the case of China, to also curb real estate speculation. Tighter monetary policy in the growth economies will cause a slowdown in China, Brazil, and India. In the case of China, this could be especially painful, since China used an unprecedented lending spree to goose their recovery. As I noted in the February 2010 letter, "With over 1.3 billion people and the need to build the infrastructure that will create enough jobs to keep the current politicos in power, China is almost forced to pursue a breakneck growth policy. In response to the global financial crisis, China adopted the most aggressive stimulus policies of any country in the world. In 2009, the Chinese government ordered their banks to ramp up lending and they did, increasing lending by almost $1 trillion. Since China's annual GDP is just over $4 trillion, this lending binge amounted to more than 25% of GDP, an extraordinary statistic. In addition, the Chinese government initiated a $570 billion stimulus plan. To say that China overloaded their economy with stimulus is an understatement." The People's Bank of China is walking a tightrope between maintaining strong growth, and curbing real estate speculation and rising inflationary pressures. The lending spree in China last year inflated a real estate bubble that will lead to a decline in real estate prices, and losses for Chinese banks. Since the U.S. and the E.U. nations will experience weaker economic growth in coming years, China's export growth will be less robust. Less export growth will cause China to have a problem with excess export industrial capacity that will be tough to replace with domestic demand. If China's economy is unable to maintain its 8% annual growth rate, the ranks of unemployed workers will increase, and lead to social unrest problems we'll watch on CNN.

In sum, tighter fiscal policy in developed countries and tighter monetary policy in the growth economies are going to lead to a global slowdown. This coming slowdown will increase the risk of a global debt deflation, since the global banking system is still impaired and burdened with bad loans. If asset prices (real estate and stock prices) renew their prior decline, the intense pressure already on the global banking system and sovereign budgets could become unbearable. What would follow wouldn't be pretty. On February 17, President Obama gave a speech marking the one year anniversary of the $787 billion "American Recovery and Reinvestment Act." President Obama proclaimed "One year later, it is largely thanks to the Recovery Act that a second depression is no longer a possibility." I wish I shared his confidence, and pray that his assessment is correct.