LEVERAGE CRISES NATURE´S WAY OF SAYING " SLOW DOWN " / THE FINANCIAL TIMES MARKETS INSIGHT ( VERY HIGHLY RECOMMENDED READING )

Leverage crises nature’s way of saying ‘slow down’

By Jamil Baz

Published: July 13 2010 16:05

Much has changed in the world economy over the past three years, but then nothing has changed. In 2007, the ratio of total debt to gross domestic product was 350 per cent in the US. In the intervening period, we have seen the near collapse of the world financial system, followed by deep recession and ultimately recovery, fuelled by the biggest monetary and fiscal stimulus in history.

It is a fact that, despite this being a crisis of leverage, total debt to GDP remains at 350 per cent in the US, and at higher levels in many of the world’s leading developed economies, for example Japan and the UK. Over the longer term, the cost of deleveraging imposes a massive burden on a country’s finances, ensuring recovery will be anaemic at best.

Although there are no definitive answers, 200 per cent of total debt to GDP is a level consistent with healthy growth, based on pre-1995 conditions. A realistic assumption is that the world can cut back its debts by 10 percentage points of GDP a year, meaning that we face 15 years of low growth or no growth at all.

Under a less optimistic scenario, this striving is all in vain: if GDP stagnates, and tax revenues fall, and interest rates rise, leverage might rise after all, despite valiant attempts to chop it. This is what happened in numerous Latin America debt crises and what looks likely to transpire in Greece or Ireland. Both these countries are entering the first stages of what will be a long period of austerity, with uncertain prospects of returning to economic growth.

There are two schools of thought on how to respond. On the one hand, we have the new and unexpected coalition of monetarists and Keynesians. The so-called “Washington consensus” sees policymakers in the US pursuing a combination of fiscal expansion and monetary stimulus, thus uniting former ideological enemies in an attempt to reprime the world financial and economic system.

On the other, there is the Austrian school, which draws on the ideas of Ludwig von Mises, Carl Menger, Friedrich von Hayek and others, and is given expression in the restrictive monetary and fiscal policy favoured by the EU today. These economists are social libertarians who believe the role of the state in society should be limited. While this conjures up visions of Tea Party extremists and hillbillies decamping to Montana, their ideas have a substantial intellectual pedigree. They see governments as vehicles for expropriating citizens. They have a low opinion of money-printing central banks and money-creating fractional banking systems.

The Austrians believe that central bank intervention results in misallocation and ultimately the destruction of capital. Far from curbing the excesses of leverage, this policy is creating more intoxicating debt and sowing the seeds of further booms, busts and crises.

Depending on who is right, prevailing interest rates are either far too high, or excessively low. Adjusting for the prevailing levels of inflation and unemployment (using the so-called Taylor rule), many argue that the Fed funds rate should be at minus 5 per cent, rather than the current near zero level. This is, of course, a large gap, implying that no realistic amount of monetary stimulus can recreate growth and increase employment, a thesis unfortunately borne out in the stubbornly high levels of unemployment in the developed world.

Austrians, by contrast, claim that credit creation by central and commercial banks leads to artificially low rates. As such, they would like to see rates higher than zero.

As you would expect from the pseudo-science of economics, much has been made of these ideological differences, but there are three hard realities we need to bear in mind.

First, when you’re bankrupt, you either default on your debts, or you save so you can repay your debts. This is neither ideology nor economics, simply arithmetics. Second, neither of the policy choices facing the world is appetising. The monetarist-Keynesian consensus offers morphine now, followed by cold turkey later. The Austrian school offers cold turkey right now, as many living in Europe are about to experience. We have the choice between another protracted leverage super-crisis – or an immediate deflation.

Third, if you are a politician, you may be under the illusion that you are in charge. But the real decision-maker is the bond market. Pressure from the bond market has forced Greece to deleverage, and it is the continuing indulgence of the bond market that allows the US to prolong the party by maintaining its twin budget and trade deficits.

And then, maybe, leverage crises are nature’s way of telling us to slow down. Policymakers can ignore this message at their own peril. In their anxiousness to avoid past mistakes, they run the risk of an even bigger mistake: fighting leverage with still more leverage, a strategy that might suitably be dubbed “gambling for resurrection”.

Jamil Baz is chief investment strategist for GLG Partners

Copyright The Financial Times Limited 2010.