Let’s begin today’s Markets and Money with a question. If taxpayers end up footing the bill when private sector companies require public money for a bailout, who’s going to foot the bill when the government requires a bailout? It’s not a trick question. The answer revealed shortly!
In the meantime, let’s also take a moment to remember that tapering is not tightening. In all the talk about slowing the pace of bond purchases, remember that even after the taper, the US Federal reserve is injecting $75 billion a month into the bond market to keep rates down. That’s hardly tight monetary policy. In alcohol terms, it’s the difference between having seven whiskey sours after dinner or eight.
Overnight, the market remains in a pleasant state of inebriation. Investors are feeling pretty good, if not yet tipsy. And there was nothing in the minutes from the December meeting of the Federal Reserve Open Market Committee to spark any concern. Markets were flat.
While markets do nothing, let’s turn our attention back briefly to China’s economy. Can you ever really have a financial crisis in a country with a command economy? This question has come up several times in the last few years. There seems to be a belief that because China’s banking system is state managed and essentially closed, the deleveraging of the financial sector is nothing more than an accounting problem. Not only do deficits not matter, credit bubbles don’t matter either!?
But it’s not that simple. In nature, we call unrestrained growth for its own sake cancer. And generally, we also know what happens with cancer. If left untreated it kills you. When nearly all the available credit in an economy is inefficiently directly toward state-backed projects with the sole goal of boosting GDP growth, it doesn’t leave any credit for a more natural allocation of resources.
Remember, lending by China’s shadow banking system has doubled since 2010. Most of that money has gone to local governments. Even the old wily speculator George Soros has recently pointed out something is rotten in the State-backed model. Soros writes that:
‘The major uncertainty facing the world today is not the euro but the future direction of China. The growth model responsible for its rapid rise has run out of steam.
‘That model depended on financial repression of the household sector, in order to drive the growth of exports and investments. As a result, the household sector has now shrunk to 35% of GDP, and its forced savings are no longer sufficient to finance the current growth model. This has led to an exponential rise in the use of various forms of debt financing…
‘The Chinese leadership was right to give precedence to economic growth over structural reforms, because structural reforms, when combined with fiscal austerity, push economies into a deflationary tailspin. But there is an unresolved self-contradiction in China’s current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years.
‘How and when this contradiction will be resolved will have profound consequences for China and the world. A successful transition in China will most likely entail political as well as economic reforms, while failure would undermine still-widespread trust in the country’s political leadership, resulting in repression at home and military confrontation abroad.’
Hmm. Soros is repeating the China bear argument but with a twist. The repetition is that China’s economy has already reached the peak of its investment-led growth. It needs to manage a transition toward more consumption and higher per-capita GDP growth (a bigger, richer middle class). And the twist?
He says the debt growth ‘cannot be sustained for much longer than a couple of years.‘ The previous bear arguments have relied on the size of the debt (in nominal terms) or have simply provided evidence that the debt didn’t build anything productive (empty cities like Ordos). So why can’t it be sustained for more than ‘a couple of years‘?
Well, it’s a good question. It comes down to the balance sheet. You have assets and you have liabilities. If and when ‘the market’ decides that the assets you have built with debt aren’t worth what you paid, you have a problem, especially if those assets aren’t producing the necessary income to service the debt.
True, much of the local government debt borrowed in China has gone for public infrastructure. The returns on this kind of investment aren’t measured in the same way as private sector projects. But the money still has to be repaid. Which means that eventually, in a roundabout way, there has to be some increase in incomes or taxes from all the spending.
But here’s another interesting question. In a closed financial system, does it matter what ‘the market’ thinks of your balance sheet? Is it just a difference of opinion? And doesn’t the opinion of the State matter the most, when it’s the State that decides how much money to create, and where to invest, and who to lend to?
Soros makes the point, or at least seems to imply, that control isn’t the real issue here. What you do with borrowed money IS the issue. And in the end, the misallocation of credit and real resources toward projects that don’t produce real wealth makes a country poorer, not richer. There’s a price to be paid. He also suggests that one way to avoid paying that price is to get angry at your neighbour and start a war.
Which will it be? Structural reforms and deleveraging, or war? Hmm. Let us know what you think by sending your comments to firstname.lastname@example.org
Finally, back to the question at the top. Who will bailout bankrupt governments? Why you will, of course! We published this excerpt from a report by the International Monetary Fund (IMF) late last year. But in case you missed it, here it is again:
‘The sharp deterioration of the public finances in many countries has revived interest in a “capital levy”- a one-off tax on private wealth-as an exceptional measure to restore debt sustainability. The appeal is that such a tax, if it is implemented before avoidance is possible and there is a belief that it will never be repeated, does not distort behaviour (and may be seen by some as fair). …
‘The conditions for success are strong, but also need to be weighed against the risks of the alternatives, which include repudiating public debt or inflating it away.
The tax rates needed to bring down public debt to pre crisis levels, moreover, are sizable: reducing debt ratios to end-2007 levels would require (for a sample of 15 euro area countries) a tax rate of about 10 percent on households with positive net wealth. ‘
Got that? In the event that public debt gets out of control (and it’s out of control nearly everywhere in the Western world) middle class wealth trapped in banks will be subject to a ‘one-time’ capital levy and whoosh! There goes 10% of your savings.
More on this tomorrow.
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