Let’s try a thought experiment. Divide the world into two camps.
1) Countries that are importing more than they export, and are increasing debt levels.
2) Countries that are exporting more than they import, and are acquiring debt claims that will provide future goods and services.
Simple enough. But now look at the two groups.
Group 1 is the developed world with its common problems:
- Bad demographics affects public and private pension systems. Both systems underfund, rather than tax / pay / borrow to fully fund.
- Sloppy, easy monetary policy in the last 25 years has led to an overage of debt finance which is now difficult to service.
- Governments were too aggressive in trying to service needs that the tax base and electorate would not validate, leading to more borrowing.
My summary for group 1 is that they became less competitive over time, and tried to maintain expanding living standards for their nations via borrowing, and encouraging borrowing. Central banks became less willing to sponsor harder downturns that would force the liquidation of bad investments. Much of that stemmed from a fear that liquidations would cascade, leading to another depression, and so, the central banks provided liquidity to support asset prices but not goods prices.
Group 2 is OPEC and the developing world. This group is more heterogeneous, and has a different set of problems:
- They have populations that are generally younger than the developed world, with some notable exceptions, e.g., China.
- Their laborers are generally less productive than those in the developed world, largely because there has not been the same level of capital investment.
- They are trying to develop industry, and trying more broadly to create societies that resemble the prosperity that the developed nations have.
- There are limits in some nations as to what freedoms will be tolerated. For some nations, the ideal is a creative, clever workforce, that is highly productive, and has no aspirations apart from their jobs. Call their representative “the new capitalist man,” willing to sacrifice himself for those above him in the economic hierarchy.
While writing at RealMoney, I would often bring up the problem of neomercantilism. Given what I have already described, the problem is that Group 2 favors their exporters and producers, and sell cheaply to consumers in Group 1. Who loses? Consumers in Group 2, and producers in Group 1. In any case, in aggregate, nations in Group 2 build up financial claims against nations in Group 1.
And there is the problem. These nations are overly indebted already, and the ability for them to make good on all of their obligations is speculative, regardless of what their bond rating is. Few of the nations in Group 1 are doing well right now, unless their economies have a large natural resource extraction component to them, such as Norway, Australia, and Canada. They look at their economies and say, “Loosen monetary policy! What do you mean we can’t loosen further? Run deficits! What do you mean our ability to do that is limited?!”
When governments are overly indebted, and the demographic profile says that things will only get worse if current policy maintains, there is a pressure to head for austerity. Keynesians will argue against this, but when you can’t easily borrow more, Keynesian remedies die. “In the long run, we are all dead.” Well, guess what, the long run has arrived, and those of us living now have to deal with the accumulated debts, malinvestments, and low interest rates that discourage saving.
It is not as if deficit spending really stimulates. It may shift money from taxpayers to some government employees, but unless that spending somehow increases the economic capacity of the economy, it is a waste. We would be better off giving money evenly to all of society, than letting the government figure out what to do with it. They will reward cronies, anyway.
As it stands, the nations of Group 1 are heading into a scenario like that of Japan. Don’t liquidate. Don’t take losses. Refinance them at low rates, and expand the monetary base to do so. Coddle the unproductive to save jobs. Turn the credit of the nation into a safety net for politically-connected industries that have grown bigger than is useful for society.
But what the markets are saying to Group 1 is simple. “You are living beyond your means. There is no way that you can fund the retirements / healthcare of so many. Beyond that, your governments spend too much in areas that are worthless. Fix that.”
The future for Group 1 is a diminution of living standards, or at least a slowdown in their growth, should financing remain available. That diminution could happen in several ways: increased inflation, bad debt liquidation, currency revaluation, unemployment with lower wages, or a combination thereof. It is not a happy future, but happiness is often having expectations set properly. Time to move expectations down. Time to start liquidating bad debts.
Group 2 is another matter. A lot depends on how much their financial systems rely on full payment in current purchasing power terms from Group 1. Defaults from Group 1 are not impossible; does your financial system rely on full repayment? It is a mistake to lend too much to anyone, particularly if it is sizable relative to your capital.
Remember the Mercantilist era. The mercantilists sourced gold dearly, and never got the full good of their investment. The same is true today of those relying on US Dollar-based investments. You are relying on the kindness of strangers. Under pressure, do you really think that the US will favor foreign creditors over domestic needs? Some things do change over time: the ethical generation that fought World War II has been replaced by a bunch of sybarites.
So Where Does This Leave Us?
It leaves Group 1 in a Japanese-style scenario, where it stagnates. It leaves Group 2 reliant on what will likely prove to be bad assets from Group 1, either from default or inflation. There are no easy ways out; Group 1 must accept lower living standards, but shows little inclination to do so. Group 2 needs to rely less on export-led growth, and should try to deepen their internal markets, and accept imports. Neither fits with the political goals of each group’s leaders. Thus the problems we face today.