Although companies have been able to tap bond markets, the recovery of global financial markets is shaky
After initially falling more sharply than in the first 12 months of the Great Depression of 1929, global output, industrial production, equity markets and trade have picked up smartly. While the recovery in advanced countries is anaemic compared to that in previous recessions, and is relatively jobless, dynamic emerging market economies seem to be firing on all cylinders once more.
Though extraordinary fiscal and monetary policies adopted by G20 countries are widely credited with having averted a second Great Depression, the global economy appears to be at an inflexion point. It is teetering between recovery in the real economy and renewed strains in financial markets, induced by a crisis brewing in the Eurozone that is threatening to boil over into the global economy. This disconnect between the real economy and financial markets is eerily familiar — it is a throwback to the confounding debate in the early stages of the global financial crisis. It was forgotten then —and is perhaps overlooked now — that the real economy lags behind developments in the financial sector. Financial markets eventually caught up with the real economy — and how! They could well do so again.
While large brick and mortar companies have been able to tap bond markets, the extent of recovery in financial markets is shallow. The banking sector started making profits through quantitative easing and taxpayer bailouts, but nevertheless it continues to deleverage, parking growing amounts of its own funds with the Federal Reserve; toxic mortgage-backed securities, which are a significant source of financial intermediation in recent years, never showed real signs of recovering their “fair market value”; interbank borrowing spreads and US housing prices, after initial signs of recovery, are under renewed distress; delinquency rates for US residential and consumer loans have continued to rise and are at levels never seen since the US Fed started maintaining records from the mid-eighties, indicating that household balance sheets are still to recover.
The flip side of the unprecedented macroeconomic response to the global crisis is the unprecedented rise in fiscal deficits and public debt in advanced countries which has not been seen since the Second World War. The over-leveraging that lay at the heart of the global financial crisis is not going away, as public overleveraging is simply replacing private deleveraging.
In the past few weeks, fears regarding sustainability of sovereign debt have once again started to roil financial markets. Sovereign borrowing spreads are rising sharply in southern Europe; corporate borrowing costs are going up; capital flows to emerging markets are falling back and safe haven flows are rising. The rescue package of ¤110 billion for Greece and the ¤750 billion financial backstop for the wider Eurozone have not quelled market fears about the health of the European banks and speculation that the crisis could spread, especially since deficits in some advanced countries outside the Eurozone are even higher.
As the German Chancellor Angela Merkel sagely observed, large deficits make governments cede control to markets since deficits need to be funded. If sovereign borrowing costs were to rise, servicing even the current debt levels would become more difficult. Markets also fear that this might constrain central banks to keep policy rates unnaturally low for an extended period of time, fuelling asset bubbles.
While an increase in public debt is the usual aftershock of deep recession and financial crises, structural deficits in several advanced countries were already rising even before the crisis on account of age-related expenditures. Moreover, the failure of transmission channels of monetary policy, the first line of macroeconomic response to downturns, placed a disproportionate burden on fiscal policy. There are now fears that cyclical deficits and anaemic growth could push countries into a debt trap unless longstanding social compacts are re-negotiated and structural reforms to raise growth are started quickly.
Governments can either grow their way out of high levels of public debt, as in the aftermath of the Second World War in advanced countries when the overall growth environment was good, and as India is currently doing, or inflate their way out, as in the 1970s following successive oil price shocks. Since long-term growth prospects in most advanced countries look shaky, market fears regarding future inflationary outcomes will not dissipate easily.
The International Monetary Fund (IMF) expects policy makers to navigate a narrow Goldilocks policy zone that is neither too early as to derail the recovery, nor too late as to provoke a market revolt. Emerging markets facing inflationary pressures should start exiting, which they are mostly doing, and advanced countries should “stagger in” exit depending on fiscal and market pressures on individual countries. The US, the issuer of the global reserve currency with few market pressures on its borrowing programme, seems to echo the IMF view. Major European countries at the epicentre of the potential crisis are in favour of front-loading fiscal exit.
Yet while long-term fears are real, and some advanced economies may indeed be in a debt trap, some of the short-term fears are overblown. Even as sovereign borrowing spreads have risen in southern Europe, they have fallen in major advanced countries during the same period. Paradoxically, despite being insolvent, a number of advanced sovereigns do not have a liquidity problem. Collectively, sovereign borrowing costs and liquidity problems can worsen only if private demand is on track. Market fears regarding future inflation and sovereign default are countervailed by the current need to seek refuge in safe havens. Indeed, in such circumstances, rising sovereign borrowing costs is something to look forward to, akin to a canary in the goldmine signalling the revival of private demand and the time for fiscal exit.
This is where lies a second paradox, what Keynes described as the “paradox of thrift”. Historical experience indicates that it is indeed possible to combine fiscal consolidation with growth, especially where there is greater reliance on expenditure control than on tax increases. Implementing structural reforms could also raise growth potential, making debt levels more sustainable and exercising a calming influence on markets. These medium-term issues are being addressed by the G20 through its ambitious Framework for Strong, Sustainable and Balanced Growth.
However, it is highly unlikely that it would be possible to have fiscal consolidation during a severe, synchronised economic downturn, more so since monetary policy transmission channels are still clogged. It is difficult to compress expenditure commensurate with the compression in revenue, especially since this has to partly substitute for the steep contraction in private consumption and investment. Even so, past experiences indicate that most of the fiscal deterioration in a downturn is through decline in revenue rather than through increase in automatic stabilisers or discretionary stimulus.
If there are cautionary lessons to be learnt from Greece, which has recently been penalised by markets for lack of fiscal credibility, there are also lessons to be learnt from Japan in the 1990s, and the US in 1937, where premature fiscal tightening resulted in both a deflationary spiral and an explosion of public debt. An undeniable virtue in normal times, fiscal chastity is of dubious value in deep recessions. Advanced countries could perhaps seek solace from the ancient Christian scholar, St. Augustine of Hippo, who famously beseeched the Lord to make him chaste, but not yet
The author is a joint secretary, Ministry of Finance Views are personal