It's not all about flows: critical issues overlooked

Posted by on 8 March 2009

The macro debate has engaged (as befitting) with many variables, yet left areas critical to tackling the crisis almost untouched.
Let me explain. Take the identity MV=PT. I'd caricature the discussion as having roamed over each of M, V, P and T - sometimes alone, sometimes in combination, sometimes in the context of a "small, open economy", sometimes in other contexts, sometimes from a neo-Keynesian perspective, sometimes not. Plenty of issues there, but let's look at what's missing.

Remember the context. According to official material, the London G20 is to provide a forum for further global discourse to take forward the agenda to:
- restore financial stability
- drive economic recovery
- progress the transition to a high-growth, low carbon global economy.
Notice two things here. First, the gobbleygook: "forum" for "discourse" for taking forward an "agenda". We are well into international bureaucrat territory here. Second, the action words "restore", "drive", and (slightly less confident) "progress". Now we all (I hope) know that forums for discourses to take forward agendas don't drive economic recovery. To be blunt, it seems that the meeting is intended to provide some positive sounding statements that show the G20 leaders strongly to be leading us toward recovery etc. I suggest that professionals should be wary of serving that agenda. If there are key issues that are intractable or highly divisive, we should say so.

So, what's my beef? I suggest four issues need far more attention. Each one points to severe limits or difficulties to the G20 driving economic recovery etc. So, all the more reason to mention them.

First, and looking at stocks rather than flows, real asset prices. We have hit the limits of leveraging the U.S. household income. Assume the financial sector can be held together but with much less leveraging than previously. Assume the U.S. government in part substitutes for missing consumption. There's still a big gap which means that substantial slab of capital assets (and human capital) globally are mis-allocated and thus mis-priced. This is important as the Chinese, U.S., Japanese and /German governments show little sign to date of wanting to take that on. The inclination is instead to try and match demand to the available supply which merely delays the adaption process. The problem is also tricky because the longer term adjustments needed are difficult to distinguish from the noise produced by destocking and postponed purchases; e.g. U.S. auto sales may be down 40% but who knows where they will settle.

Second, the stock of household and firm debt. Again, we have a lot of noise from the over-leveraging in the financial sector. But, even supposing that can be cleared away, households in the U.S. and firms in export countries and the U.S. will be left holding a lot of debt for (as per the price adjustment on assets) poor quality assets. In short, the balance sheet problem isn't just with financials and industrial dinosaurs.

Again, even assuming the financial sector can be put on its feet, lending will be limited until these balance sheet issues can be worked through.

Third, the impact of increasing the stock of government debt. Virtually every government in the world is or will be issuing more debt shortly, including those like Australia, New Zealand and Israel, who have not increased their issuance for some years. And, of course, the U.S. will be issuing lots more. Quantitative easing will see some removed from the market, but overall the marketplace will be crowded. Some issuers will be crowded out, and either there will be upward pressure on interest rates or other forms of investment (notably equities) will be crowded out also. In short, the increase stock of government debt necessary to fund the fiscal stimulii will have displacement effects, as well as being a burden on future taxpayers.

Fourth, bilateralism and the U.S. $. We all know the status of the U.S. $ as the world's reserve currency for both means of exchange and store of value purposes. Recent work by Brad Setser at the U.S. Council for Foreign Relations (Sovereign Wealth and Sovereign Power
The Strategic Consequences of American Indebtedness, CSR no 37, 2008) shows that in this decade: (1) central banks and sovereign wealth funds have almost entirely replaced private investors as the foreign holders of U.s. government bonds; (2) those from authoritarian regimes (and notably China) are increasingly dominant. What this points to is that the U.S. government debt market is decreasingly a market at all. It more resembles a series of bilateral deals or, in the case of China, a bilateral monopoly. (I've written on the robust signaling going on between China and the U.S.) Followers of game theory will know that such arrangements tend not to end happily.

In combination, I suggest that airing these four issues is a necessary counterbalance to the emerging story for the G20 that by spending more and by quantitative easing the big economies can get things rolling again.