Long-time readers know that I am a fan of Michael Pettis. I learned a ton from his book, “The Volatility Machine.” (I have the top review of his first book at Amazon.) I am quoting from his recent email, “What I will watch in 2013.”
Quoting what I can legally do from his recent e-mail, Michael Pettis says (my emphases are in bold italic):
We ended 2012 in a burst of optimism for Europe, with everyone cheering Mario Draghi for having “saved” the euro, but I am deeply skeptical. As far as I can tell nothing substantial has changed, and if countries like Spain are a little more able today to roll over their debts than they had been during the summer, so what?
It is interesting that policymakers are so pleased by an end (temporarily, I assume) to the financing crisis. One of the regular features of sovereign debt crises, and one amply revealed in Beth Simmons book on the 1930s crisis in Europe, Who Adjusts?, is that one of the complicating factors in a crisis is the tendency of policymakers (along with workers, creditors, small businesses, and middle class savers) to change their behavior in response to a crisis by taking steps that protect them from the consequences of the crisis but that also make the crisis worse. Policymakers do this by shortening their time horizons and managing from crisis to crisis, rather than by sorting out the underlying problems. The fact that Spanish policymakers are so relieved by their ability to
access near-term financing may be a case in point. It is easy to see why the worry so much about getting through the next bond auction, but at the end of the day this is not Spain’s real problem.
One way or the other, in other words, the world will rebalance. But there are worse ways and better ways it can do so. Large trade surpluses can decline, for example, because exports fall, or they can decline because imports rise. Large trade deficits can contract under conditions of high unemployment, but they can also contract under conditions of low unemployment. Low savings rates can rise with declining household income or with rising household income. Repressed consumption rates can reverse through collapsing growth or through surging consumption. Excessive debt can be resolved by default or by growth.
Any policy that does not clearly result in a reversal of the deep debt, trade and capital imbalances of the past decade is a policy that cannot be sustained. The goal of policymakers must be to work out what rebalancing requires and then to design and implement the least painful way of getting there. International cooperation, of course, will reduce the pain.
For this reason I have no doubt that over the next few years we will see the imbalances I have identified over the years in this newsletter reverse themselves, but whether they reverse in more orderly or less orderly ways will depend on policy decisions. It is likely to be political considerations that determine how quickly the rebalancing processes take place and whether they do so in ways that set the stages for future growth or future stagnation.
When there is too much debt, and things aren’t going wrong it could be an unusual perching on a mesa. The room to adjust is limited, and the cliffs are steep. China, as much as the U.S., has a tangled financial system. Too much much lending from banks to nonbanks. Too much lending to Party Members. Too much creation of Wealth Management Products, which threaten the legitimacy of financial capitalism inside China. I would rather be in the U.S. than China if I were an average person — the protections in the U.S. are much better.
As it is, central bank bureaucrats can lower interest rates for the banks, but it does not really cure the bad debt problem, because after a bout over overlending, there will be some that could not repay even if interest were reduced to zero. In one sense, that is the reality behind the zero bound. After a bull market in credit, the bear market will involve some companies/people who borrowed so much that the principal cannot be repaid even at zero interest.
The action of central banks at the zero bound may allow those that are well-off to become better-off and increase their well-being. But monetary policy cannot help those that can’t refinance.
This is why I believe that the biggest issue in restoring prosperity globally, is finding ways to have creditors and stressed debtors settle for less than par on debts owed. Move back to more of an equity culture from what has become a debt culture. A key aspect of that would be making interest paid non-tax-deductible for corporations, housing, etc., while making dividend payments similar to REITs, while not requiring payouts equal to 90% of taxable income. Maybe a floor of 50% would work, with the simplifying idea that companies get taxed on their GAAP income — no separate tax income base. Would certainly reduce the games that get played.
Anyway, those are my opinions. The world yearns for debt relief, but governments and central banks argue with that, and in the short-run try to paper over gaps with additional short-term debt that they think they can roll over forever. They just keep trying to hit the “defer” button, avoiding any significant reforms, in an effort to preserve the “status quo.”
My fear is that at some point, some significant player will follow a discordant approach which changes the terms of the tenuous equilibrium, leading to global inflation (monetize the debts for real; do not sterilize) or insist on fair payments at par (adopt a gold or other commodity-based currency standard). I think the former is more likely than the latter, but who can say? It is possible to end up with a bipolar world where both exist, or we could muddle along with the present “race to the bottom” for some time. “Crabs in a basket,” and no one ever gets out, always pulling each other down.
Time to hit publish. I am indebted to Michael Pettis, but do not write as well as he does. Get on his mailing list if you can.