If you look at the dynamic of the crisis to date you see the following flow (broadly but not exactly)
1. Sub-prime mortgages in the USA started to go under
2. Interbank lending froze as banks liabilities were unknown & collateral was of unknown quality
3. Interbank rates shot up
4. The crisis was not contained, culminating in the fall of Lehman which triggered a series of world events
the most substantial aspect of which was a loss in confidence.
5. Markets fell rates were dropped to record lows in the EU, USA and Britain.
6. Recovery began with several bailouts in the majority of nations affected.
7. This is critical – bank and private debt effectively became public debt, in Ireland’s example this was via our banks, in other countries it was in the same manner or via quantitative easing. Across Europe the ECB was a key facilitator of liquidity.
The debt has now, in many countries become a public debt issue, in Europe specifically it is a Sovereign debt issue, the like of which the US is not immune to having been downgraded by Standard & Poors rating agency.
This means that there is only one fall-back left… namely Central Banks.
We are at a cross roads in which about four outcomes are available
2. Inflate (default via the back-door)
3. Extreme austerity – which hurts the poor/middle class the most
4. Grow your way out
In Ireland the fourth option is not available as it would mean getting growth above the rate of interest we pay on debt (because otherwise the trajectory of debt does not change). While we may run a current account surplus the issue here is of a Fiscal deficit that is still weighing down on the country.
The second option is unavailable because we don’t control our currency as do any of the PIIGS.
Austerity in the absence of growth has a negative growth affect on a nation, this may or may not be in our future – while it doesn’t make sense, it is also not an option that is or isn’t within our control so it may be the road we find ourselves on; it may make our Debt/GDP ratio worse, but it may also solve our debt/revenue ratio which could in time service the former.
While we often look at the macro-picture, it is worth considering the micro. Households are the ultimate economic unit and if we examine total private sector debt over private sector income we can get a picture of the ability of the private sector to endure…
If total private sector credit is c. €335Bn and there are about 2m people in the work force earning €35,000 per year then your average person is leveraged almost 4.8 times. Using mortgage criteria – you would be hard pressed to get a loan. Then strip out the unemployed and the situation looks worse.
The clean-up is only part of the greater ongoing issue, now the developed world will have to increase living standards at a time when growth prospects are low and governments are looking to cut deficits and spending.
There is a book called ‘great waves’ by John Fisher Hackett and points out long super cycles, normally inflation is followed by deflation then price stability, if history is to repeat itself we may be looking at a 20yr run of general deflation leading to price stability.
The ‘muddle through’ solutions that will be the likely political outcome, where definitive solution after definitive solution fail to work fully will be the order of the day unless we get the ‘big bang’ solution.
It can’t just be Eurobonds because Europe is one of several key world players that are interlocked with everybody else, it would have to be Europe, the USA, Japan, China, Australia, Britain and Canada and c. 20+ other countries with strong reserve positions.
The USA is the engine of the world, while that may change in the future, it is the case in the here and now – and on a Gross debt basis if you factor in all state and local government debt the US is over 100% debt to GDP. Like all debt this must be balanced against the borrowers ability to service the debt.
Thus it is our belief that only a massive multi-lateral approach by several central banks might work – this is the ‘big bang’ we mentioned earlier. This would involve a multi-trillion swap line with all participants bailing in (lead by BIS/IMF with everybody else taking part – Fed&Treasury/BOE/ECB/BOJ etc.)
In a nutshell, there is too much debt in the world, the only viable players left are central banks, and unless we are going to explore options 1 & 3 listed above (or perhaps worse option 2?) then the massive wall of funding is the only way to do it, stop the panic once and for all, put out every potential fire by flooding the entire land.
Or we can just sit back and watch?