Will more drinks cure a hangover?

Seemingly, the world is going to hell in a hand basket (or is the darkness just a dawn precursor?).

National governments are thrashing around, talking a lot (too much?), laying off blame to distant/overseas causes, and regularly attending high-level conferences that churn out communiqués prescribing what we should do (spend more), and what we should not do (indulge in more protectionist policies).

Meanwhile, back at the ranch, the average person (frightened by all the politicians’ doom-saying) is ignoring the communiqués, and is repairing individual balance sheets by saving more. Governments, with an eye on rising unemployment and the next election, are slipping in the odd protectionist measure or ten (e.g., dairy exports in Europe, steel in the USA, cars most everywhere, and - perhaps broadest of all - the “buy local” campaign), and weakening their own balance sheets.

What’s going on? Policymakers face a very difficult policy dilemma.

The good news is that most individuals are probably doing the right thing in terms of their personal accounts. They’ve re-discovered, and are more sensitive about, risk, debt, debt-servicing requirements, and the important concept of living within their means. This is a sensible correction to past indulgences. (If you are partial to “green” sentiments, it’s all about getting back to sustainable economic ways.)

Ominously (given their power), government actions are more questionable. While individuals are attempting to correct their profligate ways, government responses (in part, at least) may reflect ultimately futile attempts to paper over - not correct - past excesses. Worse, if they fail, individuals will have to worry about servicing yet another balance sheet liability - increased public sector debt. This additional debt-servicing burden will come via increased taxation withdrawals from their incomes.

It’s really not quite as simple as this, but it’s getting close. Let me elaborate.

The current global financial and economic correction (a.k.a. crisis) has been spawned by two key effects:

1. there’s too much debt outstanding; and
2. key asset prices (houses, other property, shares) got far too high, so now they’re falling - a lot.

We can debate the underlying causes of these effects.

Was the money supply allowed to grow too fast? Were capital requirements (e.g., for banks) both inadequate and pro-cyclical in operation? Did housing policy in the USA push home ownership too far onto people who couldn’t afford the debt? Did the financial community slide away from worrying enough about risk in a mad rush to generate more profits from leveraging more debt via dodgy “securitised” assets (a new oxymoron?) and other funny bits of paper? Is it all Alan Greenspan’s fault?

The answers to these and other questions, in part, are probably “yes”.

But forget the underlying causes - for now anyway (they’ll be important for structural reforms later).

The key point is that their effects are excessive debt and (until recently) unsustainably high asset prices.

However delivered, the sustainable long term solution therefore has three elements:

• overall, the world needs to get debt back to serviceable levels;
• "serviceable" debt must have regard for underlying asset values against which that debt is secured, and income flows that provide the wherewithal to make the debt servicing payments; and
• "underlying" asset values must be sustainable if lenders are to have confidence in the viability of their lending.

Here’s the rub.

At least some asset prices may still be too high. Sustainable asset prices - and a widely held belief that they are sustainable - are important ingredients in restoring confidence in the financial system.

Outstanding debt, overall, is still too high.

Meanwhile, debt-reduction - especially if it is chasing weakening asset prices as well - necessarily imparts a dampening effect on spending, thence output, thence employment, and so on in a “vicious circle” of slowing economic activity (or worse).

But this consequence is not easy to avoid. Ultimately, we can choose when we take the pain of adjustment (sooner and sharper, or later and more protracted), but not whether we must take the pain.

Here’s where the policy dilemma arises. The transition to the longer-term solution is a very tricky road.

Unfettered action to reduce debt and allow asset prices to fall brings with it the risk of “overshooting”. That is, asset prices fall too low, more general price levels start falling, existing debt levels start rising in real terms (because they are set in constant dollar terms), resulting financial pressures lead to asset “fire sales”, further depressing prices, and so on. In “Goldilocks” terms, our adjustment pain - our “porridge” - gets too cold.

On the other hand, too much “pump-priming” in an attempt to shore up aggregate demand may blunt the needed debt reduction/asset price reduction process or wipe it out. In this case, we would put off the needed adjustment, and, worse, lay the groundwork for another, bigger, asset price bubble (and more general inflation) later. When this emerges and it becomes the priority policy problem, all the policy levers are switched to restraint, leading to a future (even bigger) “bust”. In “Goldilocks” terms, in this case our “porridge” stays too hot.

Getting a just-right “Goldilocks” balance between imminent “bust” and (another) “boom” is really hard for a benevolent dictator. It’s near-impossible for individual democratic governments with short election cycles.

But it’s worse. We have an increasingly globalised world. We all depend (increasingly) on each other. Each country’s actions affect other countries (e.g., through international trade and capital flows). A synchronised global economic downturn requires a synchronised, mutually reinforcing, national policy response.

Here we face a real test. Each national government faces strong political/short term employment pressures to try to insulate its electorate from the immediate adverse effects of the global financial and economic correction (a.k.a. crisis). But doing so means cutting the trade and capital flow linkages between nations that have been important in supporting growth in the past.

History is a guide, if we are prepared to learn its lessons. Part of the reason for the extent and severity of the Great Depression in the 1930s was national governments “pulling down the shutters” on international trade via protectionist measures. This was motivated by a desire to keep local demand allocated to their own national production and jobs, and to insulate their respective economies from the economic turmoil in other countries.

Because this was a widespread practice, it was mutually self-defeating. Sure, each country’s imports were reduced. But so were each country’s exports (after all, one country’s imports are another’s exports). Globally, then, national governments made the situation worse by stomping on trade.

Despite this very clear historical lesson, never under-estimate individual national government incentives to cheat, and hope that they can get away with it.

Today, we hear all the right-sounding platitudes via communiqués emanating from the G7, the G20 and all sorts of groups (and individual government leaders). They all decry protectionist measures. But don’t listen to what national governments say. Look closely at what they are doing. Signs of protectionism are on the rise all around the world. Governments, seeking to maximise the local demand benefits of their spending initiatives, are engaging in all sorts of protectionist measures even as they loudly proclaim their opposition to them. Union movements, ostensibly the champions of workers around the world, can be no less ruthless in cutting off their poorer brethren overseas in an attempt to protect their own locally (via “buy Australia”, and “fair trade not free trade” campaigns, and the like.)

Amplified and multiplied across a myriad of government procurement and policy areas, this trend will definitely make the looming global economic downturn much worse. It’s already happening.

What shouldn’t governments do? They shouldn’t be hypocrites, denouncing protectionism in words while embracing it in deeds. I’ll bet most if not all are guilty. Australia is, too. You don’t need to dig far to establish that. Governments can even exploit loopholes in the way the World Trade Organisation operates (just ask the Europeans). Memo WTO head, Pascal Lamy: do you sleep well at night?

In short, on protectionism, governments “talk the talk”. On action, they should U-turn, and “walk the walk”.

What role can central banks, (e.g., the Reserve Bank of Australia) play? Lower interest rates can be powerful tools, reducing debt-servicing costs, facilitating faster “de-leveraging”, and lowering hurdle rates of return for new investments. (Their additional role in lowering a country’s exchange rate is likely to be limited when all countries are reducing interest rates.)

Central banks must keep a longer-term eye on inflation, however.

What role can governments play? Well-placed infrastructure investments that pass rigorous cost-benefit tests can be useful investments both to support aggregate demand and to supply productivity enhancements. Public debt financing for these sorts of projects can be a sensible option. Economy-wide balance sheets can be enhanced by them.

What about short-term government cash handouts? Ironically, these may be more valuable in helping households “de-leverage”, and rebuild their balance sheets, than in supporting aggregate demand in the short term. Indeed, if households save these “cash splashes” rather than spend them, they are likely to do more to deal with the fundamental impediments to sustainable growth than if they spend them.

However, there’s no “free lunch”. These “cash splashes” come courtesy of increased public sector net debt. This will have to be serviced - by taxpayers - down the track.

In short, the “cash splash” demand-support strategy is likely to be a pretty ineffective option, measured against a spending-boost “pot-holing” objective. It could be better as a way of helping the private sector to accelerate the needed “de-leveraging” process. Unfortunately, this support comes at the expense of increasing the public sector’s borrowing requirement later. The taxpayer will foot the bill for this.

What role can politicians play? Mainly, shut up. Please! Confidence is both crucial and shattered at present. Your blathering about the sky falling in is making things worse.

My mother always said to me:

“If you can’t say something nice, darling, don’t say anything at all - at least not in public. It’s better for everybody in the long run. Including you!”

The newly appointed President Obama has obviously had similar advice, at least recently. Maybe other national leaders should “phone home”. It could well be in their own interests. The global economy might well be a beneficiary too.

Nearly two decades ago, Paul Keating was pilloried for saying: “this is the recession we had to have”. Only a very “courageous” politician would repeat that statement today. In my opinion, the current correction (a.k.a. crisis) is the debt-reduction/asset price deflation we needed to have, in the interests of longer-term, sustainable, economic and employment growth. But then, I’m not standing for office.

When will the current correction (a.k.a. crisis) end and recovery begin? If I knew the answer to that, I’d be very rich. I’m not, but I can point to a couple of bellwethers of recovery.

First, the more the over-committed sectors (e.g., mortgagees, highly-geared businesses) are able to “de-leverage” (i.e., reduce the net debt on their balance sheets) the closer we are to a sustainable recovery.

Second, the lower asset prices fall (prices for houses, other property, shares, etc) the closer we are to wiping out the recent asset price bubble. Indeed, for some assets, current prices may have fallen well below sustainable levels already.

Excess debt and unsustainable debt-servicing costs must be eliminated. The asset price bubble must also be pricked. These are the effects of recent excesses. They must be wiped out. Then recovery is possible.