Governments And Central Banks: Those Who Can't And Those Who Won't

Includes: EIRL, INDY, INP, PIN
by: Kevin Wilson


Serial equity bubbles have grown and then imploded since the 1990s due to excessively loose monetary policies; recently fiscal authorities have ceded all control over economics to central banks.

Debt continues to be piled on, increasing by $57 trillion globally in the aftermath of the debt crisis in 2008; however, debt is less and less effective in promoting growth.

Too-Big-To-Fail banks still represent a systemic risk in Europe and elsewhere due to weak reforms; we seem to be afflicted globally with "government by catastrophe".

Examples like Iceland, Ireland (EIRL), and India (INDY, INP, PIN) show that when attempts are made to apply non-Keynesian (e.g., supply-side) economics to recovering economies, it seems to work.

In the 1920s the U.S. markets soared as a massive credit bubble inflated. In 1929 the markets crashed from epic levels of over-valuation, with the Dow Industrials eventually losing 89% by the time the lows of July, 1932 were reached. The Dow didn't recover for over 20 years, hurting many investors, and the subsequent banking crisis of the early 1930's forced many other people into poverty as their life savings were wiped out. Worse yet, the Great Depression that followed the Crash brought to power several great world tyrannies that together were responsible for the catastrophe starting in 1939 that was World War II.

A similarly huge stock bubble grew to enormous size in the late 1990s, helped along the way by easy Fed policy, and its collapse hurt another generation of investors in the secular bear market that began in 2000. After the NASDAQ peaked in March of 2000, a nearly three-year sell-off resulted in losses of 79%. It has only recently recovered fully, after about 15 years. But in the meanwhile, yet another credit bubble grew, again aided by loose Fed monetary policies, and it eventually boosted the housing sector to record valuation levels before bursting in 2007. The S&P 500 lost 57% in the 2007-2009 disaster. This time around damage was systemic, and another Global Financial Crisis (GFC) ensued, similar in its destructive power to that of the Great Depression. By 2008 both the global housing markets and the global financial markets faced existential crises, and it took an unprecedented series of monetary and fiscal interventions around the world to save us from what should have been Great Depression 2.0. In an amazing turn of events after the worst of the GFC ended, the world's central banks decided (in the absence of any help from fiscal authorities in many countries) to continue their emergency measures essentially in perpetuity. In effect, the world's fiscal authorities in governments almost everywhere have ceded all control of the global economy to the central bankers alone.

Now, only eight years later, we potentially face yet another debacle in the coming months and years, as yet another global credit bubble has been allowed to distort prices in a wide range of assets, and governments continue to use the central bank-induced bubble as cover for their deeply irresponsible policies. In the aftermath of the 2008 global debt crisis, another $57 trillion of debt has been added to the pile, much of it in aid of financial engineering, carry trades, and other forms of speculation or malinvestment. Instead of deleveraging, which is the norm after a credit bubble collapse, what we saw instead was an early shift from private debt to public debt financing on a massive scale, followed by a general increase in debt across the board. The impact of all this debt on GDP growth has been minimal in many countries, and has been shown to be growing ever less effective as a boost to economic activity as time passes. Debt/GDP ratios have grown everywhere to high and often unsustainable levels, but they have more than doubled in emerging economies. At the same time growth has slowed, and recently the Fed's support of the dollar has caused massive ($750 billion) capital outflows amidst falling currencies, a combination that may yet cause a major financial crisis in the EM world.

In Europe a sovereign debt crisis leftover from the 2008 GFC has never really ended despite numerous bailouts and widespread "austerity," and now a new financial crisis may be beginning due to the imposition of negative bank rates (NIRP) by the ECB, Sweden, Denmark, and Switzerland. NIRP has already pulled $6 trillion in bonds into negative yield territory, profoundly distorting capital markets. There are also new regulations on banks requiring EU bondholder and depositor bail-ins, which has caused capital flight in the $100s of billions from troubled banks throughout the EU. Investors fear NIRP's effects on the banks, and they also fear that these new EU bail-in rules may be applied soon to a whole range of very weak (zombie) banks in Italy, Spain, Germany, France, and the UK. Many banks in the EU were never required to fully write off their bad loans, which now total about $1 trillion, and governments seem to think that an attitude of denial mixed with sticking it to the banks with new regulations is a plan that will work. More likely this is just fighting the last war instead of the present one. Quantitative Easing (QE) involving trillions of dollars since 2008 has boosted asset prices around the world, as intended, but has done very little to boost economic growth. Yet the Federal Reserve, ECB, BOJ, BOE, and other central banks have continued in their absurd faith-based experimentation with the global monetary and currency systems. NIRP is a sign of their increasing desperation in the face of serial failures.

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There is a common denominator amongst all of these recent and pending economic catastrophes. It is that in each case, the central banks and their respective fiscal counterparts in government have aided and abetted the growth of a credit bubble, either through ignorance or by design, and then stood by as it inevitably collapsed, wreaking havoc on millions of people, many of whom were not even participants in the Game of Riches. But in the last eight years, a fundamental change has occurred. Once the GFC credit bubble collapsed, and in the recovery ever since, the pattern changed (as mentioned above) to one in which governments have ceded all control of their respective economies to the central bankers. Why has this happened?

The short answer is that, based on philosophical beliefs and economic theories that have little empirical evidence to recommend them, the ruling elite (seemingly everywhere) have serially adopted ad hoc sets of policies that seem designed to ignore prudence, caution, and historically proven methods. In the aftermath of each new disaster over the last few years, the political and economic elite in each country have promised major reforms, but only in the aftermath of the Great Depression was meaningful reform actually enacted in most of the major economies. The reforms in the U.S. have actually let the Too-Big-To-Fail (TBTF) banks get even bigger in spite of clear evidence that their size was a major factor in the severity of the meltdown in 2008. In Europe there have been few reforms (except for those mostly cosmetic in nature), and in Japan major reforms have been discussed, but not enacted. China has until recently embraced the excesses of their post-2008 credit bubble with enthusiasm, in spite of epic levels of malinvestment and corruption, thus promoting a series of dangerous investment manias. There are many similar examples throughout the world.

The Federal Reserve and the other central banks have been part and parcel of this serial tragedy, but they have admitted nothing and are supremely complacent, as always. Their complacency is not a result of superior knowledge; rather, it is the result of the deeply satisfying conceit that goes with the psychology of unaccountability in government. No one has ever been held accountable in most governments (with the exception of a few countries like Iceland, Ireland, and Greece), or in the world's central banks for the errors that led to the impoverishment of millions in 2008, nor will they be. No one is really having their feet held to the fire now that we face major troubles again, in spite of years of unprecedented and dangerous central bank experimentation around the world. However, when government intervention is deemed the natural state of things, and failure goes unpunished, you cannot really call it capitalism anymore. Government by catastrophe is what I call it, and history suggests that it is a short-term winner for the political elite, but a tragedy for the common man.

So what is to be done? Is there any hope for the capitalist system? Is there some hope that our children won't have to face continuing economic disaster? I think some very simple and useful things could be done if there was the political will to do them. I am confident that the American people at least have had enough, and are now on the verge of picking a political outsider of sorts to be president, and that person will have a mandate for change. What happens in other countries is less clear to me, but when their respective pain levels are high enough, I believe change will come to them as well. Indeed, we already have some examples of economic success following the traumatic events of 2008, such as India, Ireland, and Iceland. What did these countries do right, and how might we emulate their success?

In Iceland, when their banks collapsed in 2008, instead of trying to save them all at enormous cost to taxpayers, the government closed the three largest banks and made investors in them take a big loss. This made sense because the banking system in Iceland had grown to 10 times GDP (!) and it would have been impossible to bailout all of that mess. An IMF loan was immediately requested for liquidity purposes, but has since been paid off. The government also immediately devalued their currency and undertook an austerity budget. The stock market in Iceland crashed to a loss of 80% almost overnight. An investigative commission was set up a few months later and so far 26 bankers have been convicted of fraud, market manipulation, and fiduciary breach of duty. Even the Prime Minister was investigated. Regulators were also investigated and reforms were put in place to improve the system. This all seems to have worked pretty well, as Iceland's economy has rebounded strongly over the last seven years. Travel to Iceland has tripled in volume, adding strength to the recovery, and the Icelandic stock market soared 51% last year. The Central Bank of Iceland has been raising interest rates due to strong economic growth.

In Ireland (see ETF EIRL) it went much differently at first, and only recently have things really taken a turn for the better. The Irish government's response to the crisis was deeply flawed at first. The banks were given a blanket bailout to its six biggest banks at stupendous cost. Later investigations, as reported by Sigrun Davidsdottir at the Fistful of Euros blog, showed that there were loans in the system to single individuals that were worth 3% of GDP. Clearly the Irish regulatory regime had failed in its duty. Even this first Irish bailout didn't really work, because the banks all eventually failed anyway. The Irish government had bitten off more than it could chew, and was later forced to ask the ECB, IMF, and EU for another bailout ($250 billion) in 2010. The government fell in early 2011, and the new Irish government attempted to impose losses on bondholders but was rebuffed by the ECB. This caused the Irish people to get stuck with an enormous liability (at least $80 billion of residual debt) that will take decades to pay off.

The Irish government did not set up an investigative body until seven years after the crisis, although it did reach similarly useful conclusions as its much earlier counterpart in Iceland. The new Irish government imposed a severe austerity program on the country in 2011, and this seems to have really done the job; in fact Ireland exited its EU/ECB/IMF bailout by paying it off in 2013. GDP growth was 5.2% in 2014, 6.9% in 2015, and is projected to reach 4.5% this year, making it the third year in a row that Ireland's growth has led the EU. One reason for this may be Ireland's 12.5% corporate tax rate, which has attracted foreign companies from around the world. Ireland's unemployment rate is still a bit high at 9.4% but is expected to continue declining to around 8.5% by the end of 2016. However, due to the damage received during the GFC, the non-financial corporate debt/GDP ratio is still high (185%), as is the government debt/GDP ratio. Still, the budget deficit has been falling rapidly, and is now only 1.5%. Perhaps the Celtic Tiger is back on track.

India (see ETFs INDY, INP, PIN) had the highest GDP growth (7.3%) of any major economy in 2015, and is expected to record over 7% GDP growth again this year, although some economists believe that the official data overstate things a bit. India's relatively new government under PM Narendra Modi has been working on land, labor, bank, and tax reforms and promoting foreign investment, with good results for the Indian economy so far. India is running a fairly high budget deficit of 3.9% of GDP, however, and there are signs of slowing activity such as weaker exports, slower railway freight traffic, weaker cement production, and flat order books. Overall though, India is doing very well in the midst of a global slowdown. However, India has seen a massive stock market sell-off, a decline in sovereign bonds, and a sharp decline in its currency over the last few months, all no doubt strongly influenced by global economic factors. There are concerns about increased government spending when deficits are already high. On the other hand the lower rupee will tend to boost exports in 2016, and lower energy costs will serve as a boost to consumers. India's debt/GDP ratio is only about 75%, comparable to the debt levels seen in Germany, the UK, or the U.S., in spite of India's status as an emerging economy. Not surprisingly given all of the above, business confidence in India is still high in spite of the global downturn. This does not mean India has turned the corner completely, because the reforms are not yet finished, the corporate sector is overleveraged, and the banking sector is weak. All of this may improve rapidly if Mr. Modi can keep his reforms on track.

What are the commonalities in these three economic recovery stories? Each country has invoked supply-side economic solutions in the aftermath of the GFC. There have been tax cuts, and/or austerity budgets, and/or bank debt write-offs, and/or currency devaluations, and/or massive reform programs in these economies, and these have collectively re-invigorated growth. Debt levels are still high, but growth is holding them in check or even allowing loan retirement in some cases. In other words, these countries are doing better than average since the GFC because their governments, instead of being paralyzed by those who can't (central bankers) or those who won't (government fiscal authorities), are blessed in having a few people who could, and did.

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