The Global Debt "Minsky Moment"

FT Alphaville points to an excellent speech by Canada’s central bank governor Mark Carney where he points to the inevitability of a prolonged period of deleveraging among the developed economies to shake off the mountains of accumulated debt. He feels that the global "Minsky moment" has arrived, and a combination of debt restructuring, inflation and growth need to be deployed.

The speech contains several superb graphics that beautifully captures the debt trap in which US and Europe have entrapped themselves. The balance sheets of households and governments on both sides of the Atlantic have worsened dramatically over the past decade or so.




Following the bursting of the sub-prime mortgage bubble, net household wealth of Americans dropped spectacularly. This wealth can be regained only through a combination of increased savings and recovery in asset values.



Europe experienced a hugely imbalanced and unsustainable economic growth after the monetary union. Cross-border lending exploded, capital was cheaply available, public spending grew, and booms ensued. This eroded competitiveness, especially among the peripheral economies with respect to Germany. Euro-wide price stability masked large differences in national inflation rates. Unit labour costs in peripheral countries shot up relative to the core economies, particularly Germany.



Financial globalisation, driven by savings glut in emerging Asia and consumption demand in the developed economies, led to the build up of external imbalances. The magnitude of these savings glut, best exepmlified by China's monstrous foreign exchange surpluses, allowed larger debt burdens to persist for longer than historically was the case.



All this was obviously not sustainable. When the bubble burst and Great Recession took hold, the consequences were severe. The World Bank estimates the world GDP output gap to be more than $7 trillion by 2017.



As these graphics reveal, all these economies built-up several critical structural imbalances over the past two decades. In all of them, compared to the previous two decades, public debts rose sharply, household wealth rose spectacularly, cross-border capital flows increased dramatically, and unit labour costs climbed. A fortunate confluence of favorable factors were inflating these bubbles and boosting economic growth.

Now that the bubbles have been deflated and the business cycle has changed direction, all these aforementioned macroeconomic indicators are naturally on the way down to their pre-bubble (not pre-crisis) norms. In many respects, this is a natural correction and there may be little that governments can do to avoid them.

Doubling per capita incomes

This graphic in The Economist highlights how average incomes in developing economies are growing more quickly than at any previous time in history.

The Great Wage Stagnation

The financial crisis and consequent Great Recession has re-ignited an intense debate about whether western capitalism is facing a crisis.

In a much read and debated e-book, Tyler Cowen has argued that the modern economy suffers from a deficit of truly great innovations, ones that dramatically improves the quality of lives and creates large numbers of jobs. He has also claimed that growth is slowing because economies have already gotten most of the innovative benefit out of previous big leaps and are now squeezing out more marginal gains.

Such trends are not exclusive to technology. There have been numerous studies which have pointed to disconcerting trends in the labour market. In the latest, Economix points to a new report from the Resolution Foundation, a British research organization, that examined trends from 10 rich countries over the 2000-07/08 period and finds weakening relationship between workers incomes and economic and productivity growth. Here are some of the findings from the report.

1. The growth rate of median pay versus economic growth per capita from 2000 to the start of the Great Recession for these ten countries indicates that wages have more or less stagnated in many countries and have lagged behind GDP growth rate in all these countries.



2. The authors represent the changing dynamics of relationship between GDP and wages using the graphic below which removes subsidies and taxes and focuses on production at basic prices or Gross Value Added (GVA) by any unit of labour engaged in economic production in both private and public sectors. It illustrates the movement from GVA at the economy wide level to the wages received by individuals as a three stage process.



3. In all these countries, the share of wages as a proportion of all employees compensation has been fallin, with the decline picking up in the last decade. Interestingly, during the same period, the proportion has either remained stangnat or even moved up in Germany, France, Sweden, and Finland.



4. The summary of findings are captured in this table. (Click on image to enlarge)

Global economy's external debt tangle

Excellent graphic in Times that captures the web of debt exposures among all major global economies. As the graphic shows, the consequences of a cascade of adverse events - defaults, contagion, credit contraction, and collapse of economic activity - can be potentially catastrophic.



(Click on the graphic to enlarge)

See also this interactive graphic.

Update 1 (24/12/2011)

An analysis of the age of debt.

The global sovereign debt crisis story so far...

From the excellent Kevin Kallaugher, the story of the global sovereign debt crisis.



Wonder when and how the story will climax.

Austerity before recovery in G-7 economies

All talk of austerity and fiscal consolidation masks the alarming fact that three-and-half years since the recession struck, the economic output of all G-7 economies, except Canada, remains below the pre-recession peak. In other words, but for Canada, none of the others, including Germany, have regained their GDP lost during the recession.



The graphic below captures the quarterly real GDP trajectories, including the latest of Q2 2011, of all the seven economies since the pre-recession peak.

The global economic power shift

The spectacular growth of emerging economies led by China in the past decade or so has dramatically altered the global economic power equations. The sub-prime meltdown and the resultant Great Recession have only accelerated this trend. The Economist has two graphics that captures the essence of this shift.



Whereas the real GDP in most developed economies is still below its end-2007 level, the same has risen more than 20% for emerging economies. This has hastened the process of convergence between the shares of the two parts of the world economy.







The rapid rise of emerging economies since 1990 has seen them close in on the developed economies in their respective global shares across a range of parameters.







If GDP is measured at purchasing-power parity, emerging economies overtook the developed world in 2008 and are likely to reach 54% of world GDP this year. Further, they accounted for three-quarters of global real GDP growth over the past decade. Though they consume 60% of the world’s energy, 65% of all copper and 75% of all steel, given the low per capital consumption, there is plenty of room for even more growth.



At a time when public debt is the biggest macroeconomic concern, emerging economies are responsible for only 17% of all outstanding government debt. The long-term outlook for these economies over the coming years appears bright, with less debt, more favourable demography and huge potential to lift productivity, besides considerable room for further growth.

World economy stares at the Lehman 2.0 moment?

The world economy is in deep turmoil, and Europe appears getting ever closer to the abyss. It is almost certain that if Spain and Italy lose access to the debt markets, it could become the Lehman moment of the Eurozone crisis.



Faced with an existential crisis, the ECB belatedly took the plunge and started buying Spanish and Italian bonds in an effort to reassure investors and signal its commitment to stand by the Euro. However, Spain and Italy pose an altogether different scale of problems.



Unlike the earlier attempts with Greece, Portugal and Ireland, Spain’s bond market, at about €650bn, is bigger than that of all the three combined and Italy’s bond market, with its €1,600bn of bonds outstanding, is smaller only than Japan and the US. Therefore, though a predominantly liquidity crisis, as opposed to solvency problems in Greece, the challenge is massive.



Hitherto, the ECB has stayed away from direct purchases, preferring to work through the European Financial Stability Facility (EFSF), which was created to lend to and repurchase Greek, Irish and Portuguese bonds. However, its €440bn corpus has already been committed to those three economies and the requirements of Spain and Italy are in a different scale than what the EFSF could support.



Paul Krugman hit the nail on its head with this excellent analysis of the problem facing the crisis-hit Eurozone economies,

"In the case of Greece and probably also Ireland and Portugal, I’d argue that we’re looking at fundamental insolvency. The debts are just too big, the required fiscal adjustment just too large even if interest rates were low, to make full payment plausible.



In the Italian case, you have big debt but also a primary budget surplus. So if interest rates stayed low, as they would if no default were expected, it wouldn’t be hard to service the debt with only modest further fiscal adjustment. But if people expect a default – and also if they believe that once a country takes on the fixed cost of default, it might as well impose a big haircut on creditors – then you could see interest costs rising to a point where default indeed becomes the preferred option.



So there is a reasonable case that what we’re seeing in Italy is a self-fulfilling crisis trying to happen, in which fear of default is precisely what leads to default. And that’s exactly the kind of case in which intervention could short-circuit the crisis. Let the ECB buy lots of Italian bonds, in effect guaranteeing a low interest rate, and the possibility of default fades – which in turn means that further intervention isn’t needed. It’s certainly worth a try."

He also makes the important point that "a country with its own currency would not be subject to the kind of self-fulfilling panic that is now arguably hitting Italy". A normal country has access to two policy levers to address debt problems that Eurozone economies do not have - ability to inflate and/or devalue away their debts. It is therefore no surprise that even as the 10 year bonds of Italy and Spain have risen to 5.27% and 5.12% respectively, that of UK, which retains the conventional policy options, trades close to Germany at 2.6%. This is despite similar macroeconomic problems and austerity programs in all three countries - debt to GDP ratios being 120%, 69% and 80% for Italy, Spain, and UK respectively.



The dangers are not restricted to public debt overhang. European banks are heavily exposed to Italian and Spanish debt and any fears of a default could devastate the global financial markets. In fact, except for German bonds, Italian debt is more widely held by European banks than any other government obligation. Europe’s 90 largest banks collectively hold Italian debt with a face value of €326 bn, and US and Spanish debt in the range of about €287 bn each. This overshadows the €90 bn in Greek debt held by the same banks.



About the Standard & Poor's downgrade of US long-term debt rating, by itself, its impact is likely to be minimal (though in confluence with other factors, it can be critical), both for the US and others. It would have been different if the Fed and other regulators had accepted it and mandated that financial institutions recalibrate their protfolios to reflect the new ratings. This would have effectively forced the default of many financial institutions as a flight from US Treasuries and a scramble for non-existent AAA assets (in huge quantities) would have ensued.



Further, as Paul Krugman recently wrote, the short-term debt arithmetic for the US is not as alarming as believed. As the example of Japan continuing to raise debt at less than 1% despite a 2002 ratings downgrade shows, the short and medium-term impact on the US economy of the ratings downgrade is likely to be marginal.



Perversely, the global nature of the financial and economic crisis benefits the US. Europe is mired in its own deep-seated problems and the emerging economies, with their dependence on the fate of advanced economies, too face the prospect of a slowdown. In such uncertain circumstances, investors take flight to "safe assets", with the US Treasuries and Gold being the two standard safe havens.



The remaining alternatives look far from ready to replace gold and US Treasuries. As Gold approaches its all-time peak, its attractiveness will diminish. Euro-denominated assets, the emerging third alternative, and assets of emerging economies are seen as too risky. This shortage of safe assets means that the US Treasuries will continue to remain the one to invest in the foreseeable future. In any case, none of the big emerging economies, led by China, can afford to pull out investments from Treasuries without suffering huge losses themselves.



The single biggest consequence of the US ratings downgrade is its role in amplifying the already high market uncertainty. The speculation surrounding the French debt position is surely a result of the American ratings donwgrade. And that decision could accelerate the downward spiral.

Catch-up growth and global convergence

Citigroup economists Willem H. Buiter and Ebrahim Rahbari, who earlier identified 11 global growth generating (3G) economies for the first half of this century, have another paper investigating the likely future sources of global economic growth between 2010 and 2050.

They use 40 year economic forecasts by Citi economists, historical GDP data for the most recent 10-year period, and available economic research on the drivers of long-term growth, to examine national-level global growth generators. They assume United States as the technology frontier country and draw the distinction between growth at the technology frontier (productivity growth at the frontier) and catch-up or convergence growth (mainly through adoption and importation of best-practice technology and know-how from the frontier countries). Naturally, they foresee most of the global growth to come from the latter source.

Their earlier 3G index aggregates some key growth drivers - gross fixed domestic capital formation; gross domestic saving; a measure of human capital (which aggregates demographic, health and educational achievement indices); a measure of institutional quality; a measure of trade openness; and the initial level of per capita income. Their final analysis and prescription about how a country grows fast

"1. Start poor
2. Start young
3. Open up to trade in goods and services and to foreign direct investment
4. Achieve reasonable political stability (the absence of significant external and internal conflict)
5. Create some semblance of a functioning market economy
6. Boost the domestic saving and investment rates
7. Invest in human capital (educate and train both boys and girls, focusing on pre-school, primary and secondary education and on vocational training)
8. Invest in infrastructure
9. Don’t be unlucky. Avoid war-like neighbours and natural disasters
10. Don’t blow it. Avoid internal conflict and populist assaults on the incentives to work, save and invest; avoid macroeconomic mismanagement, premature capital account
liberalisation and financial regulatory disasters.

Catch-up and convergence will do the rest."

If we examine the Indian economy with respect to these ten attributes/tenets, the picture is indeed encouraging, especially if point 9 is taken care of. Points 1, 2, 4, and 5 are inherent and historical advantages. Points 3 and 6 are true reform achievements. Even point 7 is being addressed. This leaves us with the real concerns - points 8 and 10.

All our immediate (inflation) and long term (growth prospects and convergence growth pace) macroeconomic challenges are closely linked with infrastructure. This is all the more so since infrastructure forms the basic platform that underpins the growth of the modern economy. We need to plan, design, raise resources and execute massively in all infrastructure sectors. And even if we mobilize the resources and show the requisite commitment to conceptualize and create infrastructure, the greater challenge is to ensure that we do not blow it up.

Here I am not worried about macroeconomic mismanagement nor financial market problems nor even corruption or internal conflicts. All these dangers always lurk around the corner and will even explode once a while, but when seen in historic perspective and when analyzing growth prospects over half-century, they are all surmountable, especially for a continental economy like India. A real worry will be with picking up the pieces from the "populist assaults on the incentives to work, save and invest". I will come back and post on this in the days ahead.

Global unemployment challenge

The biggest immediate problem facing the developed economies is arguably the persistence of high unemployment rates. As the graphic below reveals, among the major economies, apart from Germany, unemployment rate remains well above the level before the onset of the Great Recession in September 2008.



Its innovative short-work scheme that encouraged companies to keep workers on reduced hours rather than let them go and the strength of its exports sector played a major role in limiting the impact of the Great Recession on the German labor market. Labour market reforms initiated in the last decade too helped Germany retain its competitiveness during the Great Recession.

In the circumstances, contractionary fiscal and monetary policies, driven by fears of burgeoning deficits and inflationary pressures, are only likely to further shrink these economies. This danger is all the more so since aggregate demand is very weak and the private sector is in no position to lead the recovery.

Anemic economy will only exacerbate the debt crisis and increase the debt-to-GDP ratios. As to inflation, given the considerable idling resources in all these economies, it looks like a phantom menace. The immediate challenge should be to get these economies back on some stable recovery path, so that jobs are restored and created, by continuing the expansionary policies for some more time. Or else, we could be staring at a lost decade for developed economies.

The 3G economies

Citi economists William Buiter and Ebrahim Rahbari investigated the likely future sources of global economic growth between 2010 and 2050 and have come up with 11 global growth generators. The 11 3Gs are Bangladesh, China, Egypt, India, Indonesia, Iraq, Mongolia, Nigeria, Philippines, Sri Lanka, and Vietnam.


Their analysis (full report here) is based on country forecasts of macroeconomic data, historical data for the past 10 years, and research data on the drivers of long-term economic growth. They constructed a 3G index that aggregates some key growth drivers - gross fixed domestic capital formation (as a share of GDP), gross domestic saving (as a share of GDP), a measure of human capital, itself aggregating demographic, health and educational achievement indices, a measure of institutional quality, a measure of trade openness, and the initial level of per capita income.

Interestingly, three of the eleven are from South Asia and two are from Africa. Does this signal that the next half-century could belong to South Asia just as the previous half belonged to East Asia? It forecasts India to overtake China and become the world's largest economy by 2050, with India's economic growth to peak in the 2030-50 period. Further, the presence of two African countries lend credence to the growing belief that Africa is one the take-off path.

Developing Asia will contribute more than half the global economic growth over the next forty years, with Africa following behind. The combined shares of North America and Europe will be slightly more than 10%.



A reflection of Asia's pre-eminence as the engine of global economic growth is the eastward shift in the global economic center of gravity.



India is set to emerge as the largest economy by 2050



However, despite the spectacular and sustained growth, the per capita GDPs of most of these economies will remain less than half of the US per capita GDP even by 2050. This also means that the room available for convergence or catch-up growth with the technology frontier (say, the US) will be considerable, thereby boosting the economic prospects of these economies in the next half century.