The recent UK general election was notable for two things. Once more the folly of forecasting was revealed. The psephologists can now join City analysts in the dunces’ corner as all polls predicted a hung parliament, rather than a comfortable working Conservative majority.
The political discourse was dominated by talk of austerity and cuts. It worked for the Scottish National Party where the Labour Party of Keir Hardie, Ramsay MacDonald, John Smith and Gordon Brown was wiped off the electoral map. It did not work in England, where Labour painted the Tories as “the nasty party”, but failed to develop a coherent economic narrative of its own.
What none of the political class acknowledged was that in spite of some swingeing cuts to the civil service and a wage freeze across the public sector, all the talk of austerity is a myth. The UK is running a budget deficit of 5% of GDP. According to the Office of Budget Responsibility the UK’s stock of government debt will continue rising until 2019. The overall debt-to-GDP ratio including households, non-financial corporations, government and the financial sector, rose by 30% between 2007 and 2014. The UK’s total debt-to-GDP ratio now stands at 252%.
This is not just a UK problem. McKinsey shows that across more than 40 developed and emerging markets leverage is increasing. You can count the countries where deleveraging is unfolding on the fingers of one hand. Fourteen countries have increased their debt-to-GDP ratios by more than 50% between 2007 and 2014. Overall, global debt has increased by 17 percentage points and now stands at 286% of global GDP.
This debt build-up is perhaps unsurprising. Why not borrow when interest rates are at or near zero (and occasionally negative) across the developed world? Keeping money in the bank makes little sense, especially if you are a Dane and are being charged for the privilege. But there are two worrying aspects to it.
The first is the economic backdrop. The United Nations has cut its global growth forecast for 2015 to 2.8%. We are probably just one unexpected economic shock away from tipping into a dangerous slowdown. China is a favoured candidate to provide that bolt from the blue. Its debt problem is remarkable and frightening; it has quadrupled since 2007 and 50% of loans are linked to real estate. The authorities there are trying to engineer a pricking of a credit bubble without tipping the economy into a debt deflation cycle. It is a difficult balancing act.
The world economy is already close to stall speed. A recession would make debt servicing difficult for corporations faced with declining profits and households threatened by increasing rates of unemployment. Defaults will rise sharply.
What’s left?
The second concern is that all conventional means of dealing with a slowdown have been exhausted. Interest rates are at zero, debt has increased and central bank balance sheets are already bloated.
There is little left in the toolkits of governments or central banks. For the time being they are relying on their most trusted tool: the talking cure. Faced by a 15-fold rise in Bund yields and a 9% rise in the euro in one month, in late May European Central Bank (ECB) executive board member Benoît Coeuré reiterated the “whatever it takes” message. He also announced the ECB would frontload quantitative easing.
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It triggered one of the biggest one-day falls in the euro since the height of the eurozone crisis in 2011. In such a febrile environment investors can expect continued volatility this summer. The bond sell-off in Europe represents a tightening of financial conditions. It is possible that yields could go higher, but if they do expect more jawboning followed by more action from the ECB.
The ECB’s announcement of €1 trillion of quantitative easing and recent rhetoric reveal the dilemma faced by policymakers. In spite of slightly improving economic data in Europe and the inflationary effect of rising oil prices, the ECB has to avoid deflation at all costs and will doubtless be looking at the global picture with concern.
Debt deflation would be a disaster in Europe and almost certainly lead to the break-up of the eurozone. Ireland, Greece, Portugal and Spain remain among the world’s most leveraged economies, in spite of all the pain taken over the past few years. All roads lead back to the debt mountain.
Coeuré’s intervention will not be the last. If deflation persists, perhaps exported by a devaluing China desperate to maintain its growth trajectory, we may come to think of QE fondly as a modest proposal, a minor tinkering, a merely prudent form of monetary debauchery. The next moves might be an explicit commitment to a higher price level and yet more beggar-thy-neighbour currency wars, which is already implicit in the policies of many countries and economic areas.
That is what Lars Svensson suggested in his paper in 2003 (Escaping from a Liquidity Trap and Deflation: The Foolproof Ways and Others, Lars E.O.Svensson, NBER Working Paper No.10195), what former Federal Reserve chairman Ben Bernanke preached to the Japanese in Washington in 2002, when he said, “prevention of deflation is preferable to cure” (Remarks before the National Economists Club, Washington DC, November 2002). Inflation will be engineered, interest rates will stay lower for longer and longer and longer. Debt will magically inflate away and the latter day Wizards of Oz that run our markets and financial system will slap themselves on the back at Davos and Jackson Hole. It is making me feel seriously financially repressed.