August is traditionally a time for financial market crises. The current one isn’t because of the usual "thin markets, long hot summer days, everyone on holiday" scenario though, this time investors have real, concrete issues to worry about.
These were crystallized in the United States Federal Reserve’s announcement that US interest rates would stay more or less where they are until 2013 (something the Bank of England has also suggested for UK interest rates). In other words, the world’s biggest economy isn’t going to be growing in any material way for the next 18 months.
The S&P downgrade of the US is something we can ignore as being of no practical relevance (when was the last time a debt downgrade was accompanied by a fall in the issuer’s bond yields?) but the political spat over the US debt levels, coming on top of continuing euro zone sovereign debt worries, has made people realize that something has got to give.
What happens next depends on how governments decide to address the problems, and whether they are bold enough to take tough decisions now rather than leave it to their successors. If the gold pricecontinues to rise and hits $2,500 by year-end, we’ll have the answer to that question.
We are currently in the third and final phase of what a co-author of mine, Gino Landuyt, has called the “Great Debt Cycle”. The first phase was the period 1999-2007 when the seeds of the crisis of 2007-2008 were sown.
It was characterized by a mixture of deregulation, globalization, financial innovation, a shadow banking system, political and monetary intervention, currency manipulation and moral hazard issues.
At the end of this cycle, by autumn 2008, governments on both sides of the Atlantic were forced to save the financial system from complete catastrophe, at a cost of many hundreds of billions of dollars, by transferring the debt liabilities from the private to the public sector.
Large multinational banks had to be bailed out – letting them go under was simply not an option.
The end result was that public debt as a percentage of GDP rose exponentially. But the euphoria observed on the stock markets from March 2009 onwards was misplaced, because the outstanding debt did not disappear.
It simply transferred to a public sector that was already overstretched. This transfer was the start of the second phase of the Great Debt Cycle, where central banks started expanding their balance sheets.
Some of these monetary institutions were more reluctant than others, such as the European Central Bank vis-à-vis the Federal Reserve. But we see this month that even the ECB has been forced to give up its independence and become a lender of last resort to euro zone countries, buying up Spanish and Italian debt that will not be absorbed by private investors.
This is the start of the third and final phase of the debt cycle, where continuous balance sheet expansion will lead to a point where it will no longer be accepted by the financial markets. We are arriving at this stage now, and governments will make a very costly error if they don’t recognize it. There is a limit as to how much a central bank can stretch its balance sheet.
We note that the ECB’s and the Fed’s balance sheets are already leveraged approximately 1:25 times (81 billion euros of capital versus 2.3 trillion euros outstanding assets) and 1:50 times ($51 billion capital versus $2.6 trillion outstanding assets), respectively. The central banks are at risk of becoming insolvent themselves: for example, a decrease of only 4 percent of the value of the ECB’s assets is enough to wipe out its capital.
The debt issue hasn’t gone away, it’s just been transferred to the public sector. At some point it has to be repaid, and that is exactly the issue in the investor space right now – how real is the risk that it will never be paid back?
It is a rational economic reaction for the private sector to decide it doesn’t wish to keep lending to such sovereigns until they get their household finances in order.
This issue only becomes larger, not smaller, over time because an ageing population will put further pressure on welfare payments.
Just passing on the problem to the central bank is not an option anymore. Public sector expenditure has to be reduced to a more sustainable footing, unless one is in the rare position of a Germany or a Holland and able to increase productivity and export one’s way out of trouble. This option is not available to many developed economies.
What happens next? Unless governments can give a clear sign that they understand the depth of the problem and will take strong measures to address it, there is little reason for investors to be optimistic about future economic conditions at the macro level. The longer we put off the solution, the more painful the end implosion will be.
Moorad Choudhry is Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland, and Visiting Professor at London Metropolitan University.