The Keynesian Approach Has Failed
The global debt crisis continues to challenge policy makers in many countries, but especially those in China, Japan, Spain, Italy, France, Ireland, Singapore, Belgium, Greece, Cyprus, Portugal, the UK, and of course the US. Some of these countries (e.g., China) have relatively low official government debt but enormous "private sector" debt. Others (e.g., Japan) have huge government debt; amounts relative to GDP of 100% or more are considered by many researchers to be harmful to long-term growth prospects. In Japan, public debt as a percentage of GDP reached 246% in early 2016. This crushing level of debt has long been building in Japan; in fact, during the period from 1989 to 2015, Japanese government debt rose more than three-fold while private sector debt dropped by around 55%. GDP only grew by around 25% over the same time interval, as the dominance of government debt growth increasingly crowded out private credit and was used to finance increasingly unproductive activities.
I have written elsewhere that the presumptive failure of "Abenomics" could lead directly to Japan's endgame as a viable major economy, an event long predicted by economic observers like author John Mauldin and hedge fund manager Kyle Bass. Indeed, the recent decision by the BOJ to move to an explicit NIRP stance has been violently rejected by the markets, which have driven the yen up by around 12%. Japanese stock markets (especially the banking sector) have recently plunged as a result of this perceived failure of Abenomics, and just this week the BOJ refused to make any changes in policy and reiterated its belief that NIRP will work. This must be an article of faith, because there is precious little economic evidence to back the claim, at least so far.
This is a huge refutation of Keynesian theory, as I've mentioned elsewhere, with equally huge implications for the resolution of the current debt crisis; yet the financial news media seem barely aware of the story or its implications. However, it is my impression that the general public are fully aware that policy has failed (for whatever reason), and that world "leaders" don't know what to do, with one or two exceptions. This is primarily because politicians correctly believe that voters will punish any politician who attempts to fix the problem using historically effective means. The situation is worsening as politicians dither and theories like Keynesian economics continue to triumph over evidence almost everywhere. For example, in Europe, the average total national debt/GDP ratio (comprised of non-financial corporate debt, financial corporate debt, government debt, and household debt) reached about 450% several years ago, and has continued to climb ever since. However, for the UK this ratio was 950%, for Japan it was 625%, and for the US it was about 325%.
Austerity and Devaluation Have Worked
Well-known economist Lacy Hunt and other workers have shown that the historically tested solutions to debt crises are austerity and increased private sector savings, currency devaluations, and structural reforms. For example, the real reason the high debt levels of the Great Depression were substantially cut, allowing growth to resume in the 1940s, was not FDR's war spending, as is popularly believed. On the contrary - there was a huge surge in private sector savings to over 25% of GDP in 1942-45 as a result of the war's rationing programs. The increased income from exports during and after the war also added to the surge in savings. Since the savings and income surges allowed debt service to be reduced sharply, the economy was able to recover rapidly.
Now compare this to what happened in Japan over the last 25 years. The Japanese savings rate plummeted from a famous high of 25% in 1989 to a current low of 1%, leaving nothing to pay off the massive debts accrued in the aftermath of the real estate and stock bubble of the 1980s. Without a big increase in savings rates, which demographics alone militates against, Japan has no way to pay down its debt, which explains its increasingly desperate decisions, such as the adoption of NIRP. The enhanced QQE now being used by Japan has already resulted in the monetization of about 75% of the annual deficit, and that number is going to increase over time. The result at some point will be a major financial crisis affecting the whole world.
Equally daunting problems have developed in China as well. Gabriel Wildau and Don Weinland of the Financial Times have reported recently that China's total debt/GDP ratio has risen by over 89% since 2007, and is now about 237%. Others think it is much higher. Historically, such rapid increases in a country's debt are generally associated with either financial crises or prolonged periods of stagnant growth, according to Ha Jiming of Goldman Sachs. Dangerously, much of China's surge in debt has been used to refinance existing debt or build non-productive assets that add capacity to industries already struggling with overcapacity. This accumulation of nonproductive debt makes it unlikely that it will be repaid, which is strongly reminiscent of the speculative debt phase that economist Hyman Minsky noted marks the end of the credit cycle historically.
China has dealt with huge bad debt problems in the past, most famously in 1999 when "bad banks" were set up to take the non-performing loans (which represented 20% of GDP) away from the big banks and repair the latter's balance sheets. When the bonds used to fund the bad banks matured in 2009, they were simply rolled over for another 10 years. But as Tom Mitchell of the Financial Times has written recently, China may not have the bad bank option this time around since the old loans were never written off and huge new loans have been added just this year. As a result, at least 15% of commercial loans may be at risk, according to the IMF, and another banking crisis could occur.
As I have mentioned before, a study by the McKinsey Global Institute (C. Roxburgh et al., 2012, "Debt and Deleveraging: Uneven Progress on the Path to Growth") has shown that 75% of the 32 global debt crises that have occurred since the 1930s have been resolved by austerity. The remaining 25% of the crises were resolved by hyper-inflation and/or currency devaluation episodes, but all of these cases were emerging market economies with weak central banks. We have recently seen these scenarios play out in places like Zimbabwe and Argentina, and we are about to see the endgame play out for Venezuela.
Currency devaluation may actually work for the eurozone as a whole since it has a weak central bank that has already printed vast sums of money (>$3 trillion at peak) under its bond purchase, LTRO, ELA, and Target 2 regimes. In effect the ECB has recognized that Germany, with its debt/GDP ratio already above 80% (having committed to $837 billion of bailout spending in 2012), cannot be expected to continue bailing out all of southern Europe. The solution for Europe may very well be a typical emerging market solution, and either devaluation or austerity programs are major components of such an approach. Thus Mrs. Merkel (Chancellor of Germany) may actually have it mostly right, with perhaps too much emphasis on austerity and not enough on reform or currency devaluation. On the other hand, the periphery's big spenders may have it mostly wrong, with perhaps not really enough emphasis on austerity and/or structural reform, as painful as these may be, and no access to currency devaluation as a tool. The question is whether problems in the banking system in places like Italy will blow up before significant currency devaluation via QE can occur.
A rather spectacular example of a country surviving a huge debt crisis is the British Empire after the end of the Napoleonic War in 1815. Debt had climbed over a period of 100 years as one war after another was fought, reaching its zenith of 237% of GDP in the year after Waterloo, and yet the British Empire survived. A combination of currency devaluation during and after the Napoleonic War, a linking of the currency to a gold standard after 1821, and higher taxes through many decades allowed the debt to be paid off over the next 100 years. Some observers have noted that there are also plenty of modern examples of austerity working as a solution to debt crises. One very good example was the US depression of 1920-21, during which nominal GDP fell by 23.9%, CPI fell by 8.3%, and wholesale prices dropped by 40.8%. Unemployment soared from 2% to 14%. The administration of Warren G. Harding met this challenge by balancing the budget, and the Federal Reserve actually raised rates rather than lowering them. The result was a surge in industrial production during 1922 of 27.3%, and by 1923 unemployment was back down to 3.2%. This can hardly be described as a Keynesian response, and yet it appears to have worked.
Two recent examples where austerity worked rather well are Germany and Sweden. They each moved to near-balanced budgets in 2009-11 after the credit bubble and Great Recession, enjoying sustained strong growth. Apparently austerity didn't hurt them much, since they experienced annualized real GDP growth rates of 3.6% and 4.9%, respectively, over the early years of the recovery. These countries still look like the best of the bunch. In contrast, countries with high deficit spending like Greece, Portugal, Spain, Italy, Ireland, and the Netherlands have had a much tougher time of it. Indeed, John Hussman has shown that as the debt/GDP ratio rises in Europe, GDP growth tends to fall proportionately. Naturally the reverse should also be true: declining debt/GDP ratios should empirically lead to higher GDP growth over time. This is a controversial suggestion, but there have been a number of studies by Carmen Reinhart, Vincent Reinhart, Kenneth Rogoff, and their colleagues to suggest that at some level this is true.
Two other examples, Finland and Sweden in the early 1990s, involved strong recoveries from financial crises and recessions following major currency devaluations and austerity. In each country, an initial deleveraging phase was followed by substantial bank reforms and structural government spending reforms. Both countries ended up cutting their annual deficits, and then their government debt significantly within a single decade.
For still another example, we can examine what happened in the US during the inter-recession growth recovery between 1933 and 1937 (during the Great Depression but before the big savings surge of the 1940s). This huge surge in GDP to an average of 7% growth annually was caused in part by a 60% devaluation of the currency when we went off the gold standard. The growth interlude within the Great Depression ended in 1937 when other countries also went off the gold standard (causing more competition), the Fed tightened monetary policy too soon, and FDR raised taxes to an 83% top marginal rate. Only after another deep recession with high (20%) unemployment had ensued, and World War II had begun, did the surge in austerity-driven savings and export income of the war years save us from the Great Depression.
The Solutions Are Obvious, But Remain Unpopular
A huge debate continues in the financial media and amongst policy makers as to how we should deal with the global debt crisis. The debate remains unresolved and debt continues to climb. In fact, there was no significant or lasting deleveraging after the Great Financial Crisis. Although there are many complex issues involved, a discussion of which is outside the scope of the present commentary, we do know some simple things that have worked and would work again. The debt crisis has lasted longer and done more damage than was perhaps necessary, in part because the essentials learned in other crises have mostly been ignored. Austerity leading to high savings rates, combined with banking reform, structural entitlement reforms, moderate tax increases and in extremis, currency devaluation have been very effective in a variety of countries over many decades.
We can choose a better path than the one we have collectively been following, and bring economic growth back to life in the US, Europe, China, Japan, and elsewhere. What is needed is for us to act in each case on a practical basis using proven methods grounded in economic history, rather than blindly misapplying Keynesian economic theory to every situation, regardless of merit. Voters in many countries may not yet fully understand this, but their leaders will do them a great service if they set out to resolve the debt crisis using this pragmatic approach to ending the pain. The refueling and restarting of the economic growth engine could improve the standard of living in many countries relative to what it might otherwise be.
Investors in Europe, China, and Japan should probably consider the potential for currency devaluations in the next two years. I would think that the best investments in such cases would be the US dollar (the PowerShares DB USD Bull ETF (NYSEARCA:UUP)) and gold (iShares Gold Trust ETF (NYSEARCA:IAU)).
Disclosure: I am/we are long IAU.
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