With governments unable to foot the bill any longer, the markets are acknowledging the ‘elephant-in-the-room’: the still-unresolved debt-overhang is downgrading global growth.
Typically, a non-financial crisis brings about a short recession. If supported by fiscal and monetary expansion, growth regains its rising long-run trend in about one year. A financial crisis is longer. As private and public balance sheets are overstretched by excess leverage, growth slows below potential. It usually takes four bumpy years for the economy to return to pre-crisis levels of per-capita income. Reducing debt levels becomes essential to sustain the recovery.
Back in 2008, the private sector had accumulated too much debt, and the financial bubble burst. As economic output collapsed and unemployment rose, private debt was transformed into public debt via bank bailouts and fiscal stimuli. Central Banks slashed interest rates and expanded their balance sheet. Despite this swift – and massive – policy intervention, the recovery has been anemic. Over 2009 and 2010, global deleveraging led to weak demand and fragile employment growth. Many US families – with home mortgages exceeding the value of their house – opted for paying down their debt rather than consuming. Business confidence suffered. Large companies, even when cash-rich, remained unwilling to invest. Small and medium-sized firms, a major source of job creation, lost access to capital. In this frail macroeconomic environment, a wave of liquidity chased risky assets without repairing household, bank, and government solvency. Across the globe, sovereign debts ballooned. The Euro-periphery lost market access.
In 2011, a string of events – the “Arab spring”, rising commodity prices, Japan’s catastrophe, the Euro-debt crisis, the US fiscal impasse and rating downgrade, and a general loss of confidence in policymakers’ vision and abilities – led to reduced risk-appetite, equity-market volatility and worsening macro data. Most advanced economies – where output per-capita is still below its pre-crisis peak – are now likely to “double-dip”. Even emerging markets are set to slow: China – having reduced loan and money supply growth – is already showing lower-than-expected consumption and production data.
Though the global economy is in far better shape than in late-2008, tail-risks are rising. Policy tools have lost steam. While fiscal austerity will cause a recession and sovereign defaults will add to insolvency risks in the financial system, lax spending will increase credit costs, jeopardize debt sustainability, and risk bond market contagion. An extremely loose monetary policy can avoid another financial meltdown, but it is unlikely to spur lending or investment. Governments – precisely when they need to reduce expenditures – are forced to consider further stimuli, risking further downgrades. Global imbalances will only correct very slowly. Competitive devaluations are likely to increase international monetary tensions, while the centrality of the US dollar in the global system is slowly deteriorating. China’s government can afford another round of fiscal expansion, but fixed-investment – at about 50 per cent of GDP – is already high and possibly inefficient. Sovereign risks are reaching the core in Europe. A tighter fiscal union and common bonds are the way forward, but it will take time and, as parliamentary approval is needed, face political holdups. Social tensions are rising: when unemployment and headline inflation rates worsen simultaneously, the young lose patience. As income inequality worsens, more riots are likely.
Looking ahead, solvency issues need to be resolved. Bold action is required. Without debt reduction, the global economy will not achieve job-generating (not just above-zero) growth. Ideally, the US, EU and Japan should launch a five-year fiscal strategy: more stimulus (high-return investments to jump-start growth) over the next two years and credible medium-term austerity. Meaningful structural reforms are needed. Unfortunately, all this is politically improbable. Realistically, the most likely shortcut to a sustained recovery is an unfair mix of orderly debt restructuring and mild inflation. In other words, a transfer from creditors to debtors (debt restructuring) and from savers to borrowers (inflation) is the only way to clean up balance sheets whilst maintaining the integrity of the global financial system. It sounds indefensible, but debt forgiveness is as old as Babylonia, Solon’s Athens and Hadrian’s Rome. In the US, negative-equity mortgages need to be written-down. Germany will have to forgive peripheral-debt and guarantee central government debt of core countries. China will see the purchasing-power of its dollar reserves dwindle. Not a frictionless process.
Until this mix of debt restructuring and mild inflation kicks in, we should expect slow growth, recession risks, and jittery markets. While market volatility persists, capital preservation is a priority. Given high downside risks and a fragile upside, cash is king. Global investors are indeed parking record amounts in money-market funds. Still, real interest rates are negative in most countries. While a recession could create short-term deflationary pressures (because of unused capacity in good and labor markets), in the medium-term inflation is likely to make holding cash costly. Also, in an inflationary environment, borrowers will enjoy a reduction of the real value of their nominal liabilities. Distressed opportunities are likely to surface in private equity secondary market. Getting in debt to pick up assets at fire-sale prices sounds like a good idea. Safe-haven currencies will be preferred, but investors need to watch – and manage – the high foreign-exchange volatility inherent to a highly liquid post-crisis environment.
Once the crisis-induced dust settles, public market performance – now driven by news and events – will return to rely on fundamental analysis and valuations. Diverging economic performances and falling correlations are likely. In other words, future financial flows will acknowledge the structural challenges of developed economies and gradually shift their focus to emerging markets, enhancing today’s timid signs of decoupling (still more significant than in 2008).