This Time Is Different…
That was the ironic title of a major 2009 work by eminent Harvard economists Carmen M Reinhart and Kenneth Rogoff. The subtitle of the book is Eight Centuries of Financial Folly. The work offers a roller coaster ride through centuries of financial crises, inflationary tsunamis and sovereign defaults. Repeatedly through history, the authors argue, financial crises and defaults occur because the people in charge of the financial system come to believe that the iron laws of financial economics – the forces that govern valuation, price stability and the sustainability of debt – have changed and no longer apply. This time is different is what the movers and shakers always say before the roof falls in.
I can think of numerous examples of this phenomenon over the course of my own career.
In the autumn of 1987 irrational exuberance bid global equity markets up to levels that required a correction which, when it came on 19 October, wiped 20 percent off market valuations. Jimmy Goldsmith was one of the few investors to have seen it coming.
Then, in the late 1990s after the advent of the internet (or the information superhighway, as Bill Clinton then called it), the new phalanx of tech stocks were bid up to exorbitant levels. Triple-digit price-earnings ratios became standard. The word was that old-fashioned valuation models did not apply to the internet pioneers. And yet the bursting of the dot.com bubble came as a shock. By February 2000 the tech-heavy NASDAQ index reached 8,454. But on 10 March the sell-off began. One year later it was less than half that level as the progressive sell-off in tech stocks continued. By September 2002, the NASDAQ was down to 1,979. It would not regain the 8,000 level until August 2017.
The financial crisis of 2008-09 (Credit Crunch), further to the collapse of Lehman Brothers on 08 September 2008 (although it had started in March that year with the collapse of Bear Stearns), came about because bankers and investors came to believe that the use of derivatives, securitisation (anyone remember collateralised debt obligations (CDOs)?) and special-purpose vehicles had revolutionised risk management. Many of the dodgiest of these exotic beasts carried AAA ratings awarded from the likes of Moody’s. As they became undone, so the entire banking system across North America, the United Kingdom and (to a lesser extent) continental Europe faced systemic collapse and was only rescued by emergency state intervention. Even then, most leading bankers claimed that what had happened had been a liquidity crisis and not a solvency crisis, thus showing a marked lack of understanding of how bank financial risks are inter-related. (The difference between liquidity and solvency or capital risk is something I shall unpack another time – suffice to say here that they are really two faces of the same gremlin).
The long-term impact of the financial crisis and the recession that followed is that across the developed world government debt has been on a pronounced upward trend. Not only that, the era of near-zero interest rates – which only came to an end in the last phase of the coronavirus pandemic in December 2021 – was accompanied by mass money-printing (quantitative easing or QE) by the Fed, the Bank of Japan, the Bank of England and the European Central Bank (ECB).
Every undergraduate student of economics knows that there is a relationship between the quantity of money in circulation and the level of inflation. This idea has been around since Sir Thomas Gresham (1519-79), but was first modelled in modern economics by Professor Irving Fisher (1867-1947) in 1911 when he postulated the quantity theory of money, based on the identity that MV=PQ. It was developed by modern economists such as Milton Friedman (1912-2006) into an entire school of economics – monetarism.
The central bankers did not realise that excessive money-printing would eventually unleash inflation because they earnestly believed that monetary policy had become an essential tool of post-modern demand management: this time is different. They believed in a new paradigm in which interest rates would stay low indefinitely. The complete absence of monetarist thinking at the centre of policymaking from the second decade of the 21st Century is reflected by the fact that the Bank of England no longer even routinely publishes the figures for UK monetary aggregates.
The sustainability of growing levels of government debt was the main force behind the European Sovereign Debt Crisis which rumbled on from 2011 to 2016. To some extent, this was a manifestation of flaws in the design of the European currency union – the adoption of the euro as the currency of most European Union states – which had first been enacted in 1999 in the form of fixed exchange rates, and then fully in 2002 in the form of euro-denominated bank accounts and the euro in circulation as paper currency. I have written extensively about this drawn-out drama. Just to say here that the future of the euro now looks secure, given the political commitment of its adherents; but that a wide variance in bond yields of participating states has now become a permanent feature. Greece – which was bailed out by the eurozone several times – is no longer mired in financial crisis. But, like Italy and others, there is no prospect that it will be able to bring its extravagant debt-to-GDP ratio down to more historically normal levels in the foreseeable future.
The eurozone’s originally tight fiscal discipline – which stipulated that national debt should not exceed 60 percent of GDP and that each government’s annual fiscal deficit (state revenues minus expenditure) should not exceed three percent – seems like ancient history. And yet, these rules, formally suspended during the pandemic, are due to be reimposed in 2024. Such a fiscal corset could only be worn after a stringent programme of austerity – which is almost certainly politically unacceptable. How is Italy going to get from a debt-to-GDP ratio of about 160 percent to 60 percent without much wailing and gnashing of teeth? And yet Germany’s finance minister, Christian Linder, who is leader of the conservative Christian Democrats, recently announced that “Our aim is to strengthen the Stability and Growth Pact, not to weaken it”.
The austerity that Angela Merkel imposed on much of southern Europe, as the economist Wolfgang Münchau wrote in the New Statesman recently, “permanently damaged the zone’s economic resilience, fuelled the rise of the far right and drove wedges between eurozone countries”. It is interesting to note that there was a corresponding wave of anti-European sentiment in Germany itself – a country with one of the lowest debt levels in the bloc. This summer, the right-wing Alternative für Deutschland (AfD) party is now the second most popular, consistently polling over 20 percent. The pains of euroland are not allayed.
Every bull market, eventually, has its Minsky moment when investors realise collectively that they have overbought. (Named after economist Hyman Minsky, 1919-96). As government debt burdens become more onerous, so the cost of their debt will rise. There will come a point when debt service costs exceed all other types of expenditure, further damaging their credit standing and making their bonds uninvestable for all by the bravest investors. That point may be much closer than most mainstream economists think.
Born In The USA
Why did Fitch Ratings decide to downgrade the US credit rating on 2 August from AAA to AA+?
US Treasury Secretary Janet Yellen – the only Treasurer who has also previously been Chair of the US Federal Reserve – described the downgrade as “entirely unwarranted” given the country’s “economic strength.” Yet Fitch cited the prospect of a “financial deterioration over the next three years…a high and growing government debt burden… [and] an erosion of governance.”
Fitch is not saying that the US is going to go bankrupt any time soon; but credit ratings reflect the relative risk of default (what risk analysts call the probability of default or PD) over time. The reality is that the PD of virtually all western governments (with the possible exception of Switzerland) has been rising rapidly since the financial crisis. This is not just underscored by rating agencies but by independent fiscal watchdogs such as the Congressional Budget Office in the US and the Office for Budget Responsibility (OBR) in the UK.
From 2000 until today, the size of the US federal debt has multiplied by 5.6 times and now stands at $32.722trn, according to National Debt Clock. That is just under $100,000 for each US citizen or around $250,000 per taxpayer. Over that period, both US GDP and the cost of the federal government servicing its debt rose by 2.7 times. Between 2000 and 2020, the supply of money in the US economy expanded by 10 times, thanks to relentless QE. This QE mostly took the form of the Fed buying Treasuries as they were issued.
In this way, the Fed printed about US$5trn to finance colossal US budget deficits. It argued that very low short rates were “good for growth”, and that this would then help the budget deficit as tax revenues rose. The assumption was that printing money, in defiance of basic economic theory, would not cause inflation. But from now on, according to the influential French economist and commentator Charles Gave, given that interest rates have reverted to historically ‘normal’ levels, it is certain that the US debt-service ratio (that is, total tax revenues divided by the annual debt-service cost) will grow a lot faster than US GDP. The US, he says, is in a debt trap wherein all new growth accrues to rentiers, and not to entrepreneurs and workers.
The risk to the US is compounded by de-dollarisation – a substantial move by major commodity exporters to sell their products in local currencies rather than dollars. This is already happening. Saudi Arabia is now selling some of its crude oil to China in renminbi. That would entail that the demand for dollars (and Treasuries) globally would decline. The dollar would fall in value and the cost of US government debt would rise. This is the devout wish of Russia and China in their bid to promote the amorphous group of BRICS countries into some sort of rival economic bloc to the G20. It is already happening, as Saudi Arabia is now selling some of its crude oil to China in renminbi. A lot has been written of late on the pace of de-dollarisation – and I shall add my own two penn’orth shortly.
What About The UK?
The debt numbers in the case of the UK are not quite as mind-blowing as those for the USA, but, in many ways, the UK has a bigger problem because Britain does not use the international reserve currency as its own. The latest figure for the UK national debt is £2.882 trillion ($3.66 trillion) according to National Debt Clock UK. When the Coalition government took over from Labour in May 2010 the figure was under £1 trillion, so the national debt has almost tripled over the last 13-or so years. The OBR recently projected that, on current trends, Britain’s debt-to-GDP ratio will balloon from its current 101 percent to about 300 percent in 2070.
Britain has become a spendaholic state. We have not run a primary fiscal surplus (that is, tax revenues exceeding total expenditure minus interest costs) since 2001-02. In contrast, the UK ran a primary surplus throughout the 19th Century from the Napoleonic Wars onwards. Britian built up debts from the financial crisis which were not repaid during the Coalition government’s policy of austerity – in fact, state expenditure never fell, even if the rate of growth of spending was attenuated under George Osborne. Then, during the pandemic, when Mr Sunak was Chancellor, spending was wracked up to historically unprecedented levels to keep the economy afloat even though the population was forcibly confined at home.
Is there any prospective solution? Almost everyone understands that without economic growth there can be no amelioration in the national finances. But economists would say that the potential for paying down debt depends on the differential between the growth rate and the level of real interest rates which ultimately determine how much interest the government will have to pay on its debt pile.
From the conclusion of the Second World War in 1945 until the Blair years, the British economy grew by a long-term average of 2.7 percent per annum. Today, growth is fragile and, even if there is a modest recovery next year (which is highly questionable), the economic commentariat does not expect the UK to grow by much more than 1.5 percent thereafter – unless there is some miraculous turn-around in our productivity growth. Meanwhile, interest rates have snapped back, as we know, to historically more “normal” levels and are likely to remain at 5-6 percent in the short-term at least; although with inflation running at 6.8 percent, the real interest rate is actually negative. That is good for governments to the extent that inflation erodes the value of the stock of national debt in real terms.
However, with about one quarter of Britain’s national debt index-linked, and with QE having shortened the average term of government bond issues, government borrowing costs have been rising sharply. The OBR’s projection cited above admits that it does not assume that interest rates will rise as debt levels become more unsustainable over time and that it ignores future shocks such as financial crises, extreme supply chain disruptions (as occurred during the recent pandemic) and wars.
Inflation will not reduce the burden of the future bill for pensions which is likely to grow given an ageing population which will have additional recourse to the flailing NHS. Moreover, government fiscal policy is constantly scrutinised by the financial markets. As the Truss-Kwarteng kamikaze mini-budget demonstrated, governments will be punished for unfunded tax cuts by having to pay more for new debt. Even the Sunak-Hunt government, the mantra of which is steady she goes, must now pay more for its new debt than Italy or Greece – and UK bond yields are still rising. On Thursday (22 August) the yield on the 10-year gilt was running at 4.426 percent. The yield on the two-year gilt was 4.95 percent.
There are reasons to suppose that more indebted nations grow more slowly than ones with low levels of debt. Reinhart and Rogoff have argued this and have flagged the 100 percent debt-to GDP level as the tipping point when governments risk losing control of the economy – though most economists would say that they have failed conclusively to prove these conjectures. But we know instinctively that the more debt an induvial or a state accumulates, the more difficult it becomes to pay it down – even if most left-inclined economists like Paul Krugman assert that nation states are not households and can continue borrowing indefinitely.
The Ultimate Ponzi
Extreme libertarians such as the commentator and guru Doug Casey assert that the welfare state is essentially a Ponzi scheme. I do not identify with extreme libertarianism, but I find the analogy illuminating. Casey believes that, to the extent that welfare of transfer payments across the West are financed with new debt, given perennial fiscal deficits, they rely on more and more young taxpayers entering the workforce who pay additional taxes to keep the system going. As long as the workforce and the economy – and therefore the tax base – continues to grow by more than the increase in debt service costs, the system is sustainable. But if medium-term economic growth falls below the increase in debt service costs, the entire system faces collapse. That is exactly what he thinks is now in play.
If you believe that we are just going through a temporary phase of low growth – a historic blip, if you will – then there is nothing to worry about. Technology – AI, biotech, quantum computing, the rest – will soon impel a new spurt of growth across the West and everything will be OK.
On the other hand, consider the phenomenon that a new generation of economists is gaining influence which argues that growth in itself is inherently bad, even if they believe that large-scale immigration is inherently good. Kate Raworth, author of Doughnut Economics, describes herself as a renegade economist – presumably someone who seeks to redefine the academic discipline. She was influenced by the work of Donella Meadows (1941-2001), co-author of The Limits to Growth (1972) which seems to have a cult following these days.
It is interesting that many of this new breed of economists who oppose growth favour such progressive causes as a Universal Basic Income (UBI), even though I have no idea how such a scheme could be financed outside a much wealthier system than the one in which we live.
Tomorrow Never Comes…
But who really cares about fiscal scenarios that might unfold in 10-20 years’ time? The markets focus on current news flow.
On Tuesday (22 August) the markets were cheered by the news that the UK government did not borrow as much as expected. Thus far, since the beginning of the financial year on 06 April, the UK government has borrowed only £56.6 billion. This is £13.7 billion more than the same period in 2022, according to the ONS. But it is £11.3 billion less than the OBR predicted in Mr Hunt’s 15 March budget. This is because fiscal drag (witness the refusal to raise tax bands despite inflation) is bolstering tax receipts. Income tax and national insurance revenues are running at 4.3 percent above the OBR’s March forecasts, while an 8 percent rise in VAT revenues above the OBR’s estimates has been boosted by higher retail prices.
This moderately good news prompted calls by some Tory MPs to cut taxes. But then, you would not expect the turkeys to vote for Christmas. Instead, they will continue to believe that this time is different.
Afterword
I was sad about the passing of old Parky. Sir Michael Parkinson (1935-2023) occupied a niche in British TV broadcasting which exists no longer. In the mid-1970s he had the good fortune to develop the American-inspired chat-show format at exactly the moment when the Hollywood greats were liberated from their onerous film contracts and felt free to spout their spoken memoirs in a quest for post-stardom pensions. His ordinariness was engaging to A-list egos who, in those days, still had a sense that all celebrity is bunk. It is only since the advent of social media that famous people take themselves seriously.
Yes, I remember Emu attacking Parky; but actually, there were much better programmes that we watched, in the 1970s, as a family – nestling on recently acquired sofas. Surely, the 70s – I admit, the decade that taste forgot, in the realm of fashion, with those kipper ties, bell-bottom trousers and ludicrous lapels – was the golden age of British television.
Consider I, Claudius (1976), in which the late, great John Hurt played the cruel but mesmerising Emperor Caligula. Or Colditz (1972), starring Bernard Hepton and Robert Wagner. Or the BBC’s adaptation of Tolstoy’s War and Peace (1972) in which the young Anthony Hopkins played Prince Pierre Bezukhov.
People younger than I think that Netflix is great – but they have no idea of just how good the BBC was in the 1970s. How things have changed.