Our quarter-century penance is just starting

Never in modern times has there been such a flat contradiction between the euphoria of markets and the stern warnings of officialdom at central banks and financial watchdogs. By Ambrose Evans-Pritchard
 www.telegraph.co.uk 29 Aug 2009 Corporate credit has seen the steepest rally in almost a hundred years, according to Morgan Stanley. Hedge funds are reviving the final bubble play of early 2007, writing put options on long-dated “volatility” contracts to wring out extra profit. It is as if the Great Contraction – as the Bank of England now calls it – was just a random shock, as if we should naturally expect “V-shaped” resurgence to take us back to where we were. Yet that is what precisely we are being told will not and cannot happen. “The current financial crisis is unlike any others,” says the Bank for International Settlements. Lasting damage has been done. The “cumulative output loss” is likely to reach 20pc of GDP in the major economies. The message is the same at the International Monetary Fund. “The world is not in a run of the mill recession. The crisis has left deep scars. In advanced countries, the financial systems are partly dysfunctional,” said Olivier Blanchard, the Fund’s chief economist. Mr Blanchard said an IMF study of post-War banking crises led to an unpleasant finding. “Output does not go back to its old trend path, but remains permanently below it.” Then the sting: we are exhausting the limits of fiscal stimulus. “The average ratio of debt to GDP in the G-20 economies was high before the crisis, and is forecast to exceed 100pc in the next few years”. We cannot add debt, so the IMF says we must draw down our future pensions and future health spending to keep today’s economy afloat. “A modest cut in the growth rates of entitlements can buy substantial fiscal space for continuing stimulus.” Shouldn’t bulls be sobered that the bastion of hard-nosed orthodoxy feels the need to talk in such terms, or that White House officials are preparing the ground for another round of emergency spending even as it reveals that fiscal deficits will reach $9 trillion over the next decade. This is $2 trillion worse than feared in March, and based on rosy growth assumptions. It has certainly alarmed US retail tycoon Howard Davidowitz. “As a country we are out of control, we’re in a death spiral,” he said. All that has happened over this crisis is that huge private losses have been dumped on society: but the losses are still there, smothering the economy. Taxes must rise. Debts must slowly be purged. “As long as economic growth relies on the state, you cannot talk about durable recovery,” said European Central Bank member, Yves Mersch. Nobel Laureate Paul Krugman said the US needs another fiscal blast for “political reasons”, alluding to the Great Depression. It was Phase II from late 1931 to early 1933 that tipped half Europe into fascism and brought America soup kitchens. Although such a fate has been averted this time by government action, the Atlanta Fed says the true rate of US unemployment is already 16pc (not 9.4pc), worse than early 1931 levels. Official youth unemployment is 34pc in Spain, 28pc in Latvia, 25pc in Italy, 24pc in Sweden, Hungary, and Greece. I have some sympathy with the Krugman view, but entirely disagree over methods. The key is to prevent a debt deflation trap – note that producer prices have fallen 8.5pc in Japan, 7.8pc in Germany, and 6.8pc in the US. The least dangerous medication is Quantitative Easing a l’outrance (ie printing money), as the Bank’s Mervyn King clearly thinks. This does not add debt. It prevents the real value of existing debt from rising. Mr Krugman undermined his case by citing Italy as a country that faced public debt of 118pc of GDP in the early 1990s without disaster. Actually, it has caused disaster, even if it has taken this recession to expose the damage. Debt will rocket to 125pc next year (IMF forecasts), and then -- one fears – off the charts. We know what caused this crisis. The West kept short-term interest rates too low for a quarter century, luring society into debt: and the East held down long-term rates by flooding bond markets as a side-effect of their mercantilist strategy (ie suppressing currencies to gain export share). The outcome was over-investment, excess capacity, and too much debt among those supposed to buy the goods. Has any of this changed? No. Have we cleared the excess plant? No. Jeff Wenniger from Harris Private Bank says an army of baby-boomers have seen their old age plans shattered by the housing bust. Their nightmare is here. They will have to spend less, and save more. “Generational destruction of a society’s balance sheet down not rectify itself in a matter of months”. How about a quarter century?