“The toxic effects of policies have now created conditions for a new financial crisis”

satyajit dasDear Reader

This is the second part of the interview with economic commentator and globally best-selling author Satyajit Das.

Das is an internationally respected commentator on financial markets and economics He is credited with predicting the current financial crisis. He has also featured 2010 Oscar-winning documentary Inside Job.

I would like to state here that I actually understood how financial derivatives caused a major part of the current financial crisis only after reading Extreme Money authored by Das. Until then my understand was shaky.

His first general book Traders, Guns and Money is a master class on derivatives, given that Das’s technical tomes on financial derivatives running into thousands of pages, remain a standard reference on Wall Street.

In this interview I speak to Das around his new book The Age of Stagnation—Why Perpetual Growth is Unattainable and the Global Economy is in Peril. Like his earlier books this book is also a terrific read and a must for anyone who seriously wants to understand how things haven’t really changed in the aftermath of the financial crisis, and why the future continues to remain bleak.

This is the second part of a three-part interview. The concluding part will appear tomorrow.

Happy Reading!
Vivek Kaul

 

Do you see all the debt that has been accumulated by governments over the years, ever being repaid? How do you see this playing out?

Interestingly, total public and private debt in major economies increased not decreased since 2008. The Table below sets out the changes in debt levels in the global economy:

Global Stock of Debt Outstanding

(US$ Trillion, Constant 2013 Exchange Rates)

  2000 2007 2014 Compound Annual

Growth Rate (%)

Type of Debt       2000–2007 2007-2014
Household 19 33 40 8.5% 2.8%
Corporate 26 38 56 5.7% 5.9%
Government 22 33 58 5.8% 9.3%
Financial 20 37 45 9.4% 2.9%
Total Debt 87 142 199 7.3% 5.3%
Total Debt (as % of GDP) 246% 269% 286%    

Source: Richard Dobbs, Susan Lund, Jonathan Woetzel and Mina Mutafchieva (2015) Debt and (not much) deleveraging, McKinsey Global Institute: 2

Total debt has continued to grow at a slower rate than before the GFC but remains well above the corresponding rate of economic growth. Higher public borrowing has largely offset debt reductions by businesses and households.

Could you tell us a little more about that?

Between 2007 and 2014, the ratio of public sector debt to GDP in advanced economies increased by 35 percent of GDP, compared to an increase of 3 percent between 2000 and 2007. The increase in government debt reflected the effects of the GFC. It was designed to support the financial system. Government spending sought to boost demand and growth. The increase in debt predictably was highest in the worst affected countries, such as the UK, Greece, Spain, Portugal and Ireland.

Given slow growth, low inflation rates and the balance between tax revenues and expenditure and inflation rates, government debt to GDP ratios are forecast to rise for the foreseeable future in the US, Japan and many European countries. In many countries, government debt has reached levels which are unsustainable. It is unclear how these highly indebted economies will reduce the level of government debt.

Why do you say that?

Debt can only be reduced through strong economic growth. Many economies in the world today have debt-to-GDP ratios of 300 percent. If the average interest rate is 3 percent, then to meet interest payments the economy would need to grow at 9 percent (300 percent [debt] times 3 percent [interest rate]), an unlikely nominal rate of expansion.

The alternative is debt forgiveness, defaults or inflation. But all these steps, other than growth are not without consequences. Savings designed to finance future needs, such as retirement, are lost. This in turn results in additional claims on the state to cover the shortfall or reduce future expenditure which crimps economic activity. Significant write-downs on sovereign debt would trigger major crises for banks and pension funds. The resulting losses to savers would trigger a sharp contraction of economic activity. National governments would need to step in to inject capital into banks to maintain the payment and financial system’s integrity.

In One Lesson: The Shortest & Surest Way to Understand Basic Economics, Henry Hazlitt summarised the problem: “Everything we get, outside of the free gifts of nature, must in some way be paid for. The world is full of so-called economists who in turn are full of schemes for getting something for nothing. They tell us that the government can spend and spend without taxing at all; that it can continue to pile up debt without ever paying it off, because ‘we owe it to ourselves’.” It is useful to remember that.

One of the things you write is that the stock markets have decoupled from the real economy. Why do you say that?

Equity prices now do not correlate to fundamental economic factors, such as nominal gross domestic product or economic growth, or, sometimes, earnings.

Writing in the Financial Times, James W. Paulsen, chief investment strategist at Wells Capital Management, advised Investors not to be too concerned about slower earnings growth. Mr. Paulsen forecast a 2,600 target for the S&P 500, or an annualised five-year return in excess of 10 per cent, including dividends. He warned investors about “becoming too myopically focused on these mainstream issues lest [they] miss what could be the second confidence-driven bull market of the post-war era”. Given that shares represent claims on the earnings derived from the real economy, this is puzzling.

It indeed is…

Veteran Legg Mason fund manager Bill Miller once observed that: “The common view [is] that the weak stock market reflects a weakening economy. But we think the converse is more likely: the weak stock market is causing the economy to weaken”.  Equity analyst Laszlo Birinyi supported this view of causality: “The relationship between the stock market and the economy is tangential, not causal”. It is not clear why the equity market should drive the real economy, rather than the other way around.

There may be some possible explanations for the divergence between the real economy and equity prices. First, share values are increasingly affected by opaque accounting and what one observer termed the ‘expectations machine’; that is, manipulating and beating expectations rather than absolute performance criteria. Then there are higher levels of corporate activity such as share repurchases and mergers and acquisitions which affect values.

Second, equity markets have become instruments of economic policy, as policy makers try to increase asset values to generate higher consumption driven by the ‘wealth effect’. Monetary measures, such as zero interest rate policy and quantitative easing, distort equity prices. Dividend yields that are higher than bond interest rates now drive valuations. Future corporate earnings are discounted at artificially low rates.

Any other reasons?

Third, the increased role of high frequency trading (“HFT”) has changed equity markets. HFT constitutes up to 70% of trading volume in some markets. The average holding period of HFT trading is around 10 seconds. The investment horizon of portfolio investors has also shortened. In 1940, the average investment period was 7 years. In the 1960s, it was 5 years. In the 1980s, it fell to 2 years. Today, it is around 7 months. The shift from investing for the long run has fundamentally changed the nature of equities, with momentum trading a larger factor.

Fourth, the increasing effect of HFT has increased volatility and the risk of large short term price changes, such as that caused by the ‘flash crash’, discouraging some investors.

Fifth, alternative sources of risk capital, the high cost of a stock market listing, particularly increasing compliance costs, increased public disclosure and scrutiny of activities including management remuneration as well as a shift to different forms of business ownership, such as private equity, have changed the nature of equity market. New capital raisings are increasingly viewed with scepticism as private investors or insiders seek to realise accreted gains, subtly changing the function of the market.

Sixth, financialisation may facilitate market manipulation, whereby the corrosive impact of insider trading and market abuse erodes investor confidence.

Financial instruments, such as shares and their derivatives, are intended as claims on real businesses. Over time, trading in the claims themselves have become more rewarding, leading to a disproportionate increase in the level of financial rather than business activity.

You write: “politicians and central bankers gambled that growth and increased inflation would over time correct the problems”. But things did not turn out as they expected. What went wrong there?

Policy makers assumed that the Great Recession of 2007/8 was a cyclical downturn not a structural change. George Soros got it absolutely right: “[It] resembles other crises that have occurred since the end of the Second World War at intervals ranging from four to 10 years…there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years.”

And what happened because of the mis-diagnosis?

Given the mis-diagnosis, policy maker reacted with their usual responses: fiscal stimulus and looser monetary policy (low rate and then QE). This was never going to work as the debt overhang meant private economic activity did not recover to pre-crisis levels. Low rates did not actually encourage borrowing and spending.

The GFC left a legacy of large debts, forcing households to reduce spending so as to repay borrowings, with low-income households reducing spending by twice as much as richer households. The debt overhang and caution about borrowing has reduced the impact of low interest rates. Households are unwilling or unable to increase debt. The fall in house prices in some countries, and the resulting decline in household wealth, has made borrowing difficult; lending against home equity has decreased. Banks have also tightened lending standards, in response to loan losses. These factors mean that a consumption-based economic recovery is unlikely without income redistribution to households with a higher propensity to spend, or finding a new source of demand. The lack of demand has resulted in weak investment, also slowing growth.

As result, the global economy is locked into a path of low growth and low inflation tending to disinflation or deflation. That would be fine if it were not for the high levels of debt which will spiral out of control in such conditions.

So what was really needed?

What was needed were major structural changes: dealing with the excessive debt, dealing with global imbalances, addressing the unfunded entitlements which affect public finances and rebalancing between the real and financial economy. Then, there were other issues like demographics, slowing productivity and innovation as well as the problems of inequality, environment and scarce resources. But no government has had the political courage to tackle these issues to the degree necessary.

So what they did was make a bad situation worse by increasing debt. The toxic effects of the policies have now created the conditions for a new financial crisis.

In essence, they tried to do the wrong things better rather than do the right things badly.

To be continued…

Disclosure: Satyajit Das wrote the foreword to my book Easy Money: Evolution of Money from Robinson Crusoe to the First World War

The interview originally appeared in the Vivek Kaul Diary on January 28, 2016

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About vivekkaul
Vivek Kaul is a writer who has worked at senior positions with the Daily News and Analysis(DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System , the latest book in the trilogy has just been published. The first two books in the trilogy were published in November 2013 and July 2014 respectively. Both the books were bestsellers on Amazon.com and Amazon.in. Currently he works as an economic commentator and writes regular columns for www.firstpost.com. He is also the India editor of The Daily Reckoning newsletter published by www.equitymaster.com. His writing has appeared across various other publications in India. These include The Times of India, Business Standard,Business Today, Business World, The Hindu, The Hindu Business Line, Indian Management, The Asian Age, Deccan Chronicle, Forbes India, Mutual Fund Insight, The Free Press Journal, Quartz.com, DailyO.in, Business World, Huffington Post and Wealth Insight. In the past he has also been a regular columnist for www.rediff.com. He has lectured at IIM Bangalore, IIM Indore, TA PAI Institute of Management and the Alliance University (Bangalore). He has also taught a course titled Indian Economy to the PGPMX batch of IIM Indore. His areas of interest are the intersection between politics and economics, the international financial crisis, personal finance, marketing and branding, and anything to do with cinema and music. He can be reached at vivek.kaul@gmail.com

2 Responses to “The toxic effects of policies have now created conditions for a new financial crisis”

  1. Thanks for the insights. I wish only to comment that public debt which benefits the weaker
    sections of the population provides sustainable employment for reducing debt in the
    economy like the IT sector or road construction while debt which benefits the oil intensive
    richer sector during times of high oil prices increases instability and when cutbacks on
    consumption are imposed instability sets in first in the equity market and then in the economy.

  2. hcparekh says:

    STRUCTURAL REFORMS ?

    Speaking at the Global Business Summit yesterday , Shri Arun Jaitley said :
    ” We will introduce Structural Reforms in the forthcoming Union Budget ”
    What is the current structure of Union Budget ?
    # SOURCES of REVENUE
    * Taxes ( Direct + Indirect )
    * Borrowings ( Domestic + Foreign )
    * Sale / Leasing of Assets ( PSUs + Natural National Resources )

    # DEPLOYMENT of REVENUE
    * Administrative Expenses ( Salaries / Pensions / Maintenance / Subsidies , etc )
    * Interest ( + Principal Amount ) on borrowings
    * Developmental Expenses ( Creation of new Assets / Infrastructure )
    * Lending

    Broadly speaking , this is the current structure
    Most of the time , all that the successive Finance Ministers have done is to slightly ” Increase / Decrease ” the ” Sources and / or Deployment ” of the funds , here and there
    Once in a while , some Finance Minister , even introduced altogether NEW source or a NEW way to spend the revenue !
    But so far , no one has attempted to change the FUNDAMENTAL STRUCTURE !
    I wonder whether Shri Jaitleyji’s BUDGETARY REFORMS would incorporate the following Structural Changes for which , I have sent to him ( and to most of his cabinet colleagues ), dozens of emails ? :

    * Total abolition of Personal Income Tax ( Revenue Loss of approx Rs 2.5 lakh*crores )
    * Introduction of 2% Bank Transaction Tax – BTT ( Revenue Gain of Rs 15 lakh*crores )
    * Decreasing Corporate tax slab-rates based on No of permanent employees ( to encourage job creation )
    * Perpetual Amnesty Scheme ( no questions asked as to the source for CASH deposits in Jan Dhan Accounts , if
    funds from these Accounts are invested in Govt approved INFRASTRUCTURE SPVs )
    So far , Rs 30,000 Crores have been deposited in Jan Dhan Accounts . With introduction of this REFORM ,
    that figure will rise a thousand times to Rs 30,000,000 Crores , within one year !
    These investments will generate 10 million jobs each year and raise our GDP to 10 % in 2016-17 !
    * Transferring 10% of GST ( ie 1.8 % out of 18 % ) to PPF accounts of the buyers ( increase Domestic Savings )
    * Embedding of RFID chips in Currency Note ( read Kurzweilai.net ) to solve twin problems of BLACK MONEY and
    CORRUPTION
    * Introducing ” Budgeting By Objectives ” ( instead of Monetary Allocations, setting Physical Targets for Ministers )
    * Quarterly Performance Review of ” Targets vs Actual Achievements ” to be published on Govt web sites
    * Thru an Online Opinion Poll , involving citizens in framing of the Ministry-wise Physical Targets before the budget

    After second World War , German Economy was in shambles
    68 years later , Germans are still thanking their then finance minister , Ludwig Erhard , for the miracle (“Wirtschaftswunder,” German for “economic miracle”) he brought through his ” Out of the Box ” reforms to revive the German Economy
    I hope Shri Jaitley displays similar courage on 29 Feb 2016 – even if he is not bothered being remembered or not !
    ——————————————————————————————————————————-
    hemenparekh.in / blogs
    31 Jan 2016

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