The doomsday cycle turns: Who’s next?

By Don Alexander, MBA
Associate, RSD Solutions Inc.
(Mr. Alexander also lectures at NYU and SunySB)

Industrialized countries today face serious risks – for their financial sectors, for their public finances, and for their growth prospects. The authors explain through our financial systems, we have created enormous, complex financial structures that can inflict tragic consequences with failure and yet inherently difficult to regulate and control.

There is a common problem underlying the economic troubles of Europe, Japan, and the US: the symbiotic relationship between politicians who heed narrow interests and the growth of a financial sector that has become increasingly opaque. Bailouts encourage reckless behavior in the financial sector, which builds up further risks – and often lead to another round of shocks, collapses, and bailouts.

This is called the ‘doomsday cycle’ and is described in a short communique titled The doomsday cycle turns: Who’s next? (Simon Johnson & Peter Boone, VOXEU, September 21^st).  The cycle originates when the financial system is allowed to grow creating excessive borrowing and leverage, but is hidden by the complexity and opaqueness.

The problem is that the modern financial infrastructure makes it possible to borrow a great deal relative to the size of an economy – and far more than is sustainable relative to growth prospects. The expectation of bailouts has become built into the system, in terms of government and central bank support. But this expectation is also faulty because, at times, the claims on the system are more than can ultimately be paid.

This system distorts incentives and that may result in unforeseen consequences.  For politicians, this is a great opportunity to buy favor and win re-election while delaying unpopular decisions.  For bankers and financiers of all kinds, this is easy money and the opportunity to earn an outlandish bonus.  For the broader public, none of this is clear – until it is too late.  The regulated financial sector has little interest in speaking truth to authority; that would just undercut their business. Banks that are ‘too big to fail’ benefit from giant, hidden and very dangerous government subsidies. Yet despite repeated failures, many top officials pretend that ‘the market’ or ‘smart regulators’ can take care of this problem.

The complexity and scale of modern finance make it easy to hide what is going on. The issues are abstract and lack the personal drama that grabs headlines. The policy community does not understand the issues or becomes complicit in the schemes of politicians and big banks. The true costs of bailouts are disguised and not broadly understood. Millions of jobs are lost, lives ruined, fiscal balance sheets damaged – and for what, exactly?

The question is: Who will be hurt next by this structure?  There are three prominent candidates are Europe, Japan and the US.  In Europe, the crisis originated from a flawed design of the euro and shows little sign of emerging from the crisis any time soon.  In the US, excessive private sector borrowing is showing some signs of improvement as the economy continue to delever.  While Japan, faces the impact from an aging population and economic stagnation. 

Through our financial systems, we have created enormous, complex financial structures that can inflict tragic consequences with failure and are difficult to regulate and control.  The lesson from all these troubles is clear: the relatively recent rise of the institutions of complex financial markets, around the world, has permitted the growth of large, unsustainable finance. We rely on our political systems to check these dangers, but instead the politicians naturally develop symbiotic relationships that encourage irresponsible growth. The nature of ‘irresponsible growth’ is different in each country and region – but it is similarly unsustainable and is still growing. There are more crises to come and they are likely to be worse than the last one.

www.voxeu.org/article/doomsday-cycle-turns-who-s-next -

The Good, the Bad, and the Ugly: 100 Years of Public Debt Overhang

By Don Alexander, MBA
Associate, RSD Solutions Inc.
(Mr. Alexander also lectures at NYU and SunySB

Throughout the past century, numerous economies have faced public debt burdens (debt/GDP) as high, or higher, than those prevailing today.  History offers lessons for countries struggling with high public debt levels.  Already, a number of countries are approaching a debt to GDP ratio of 100%, which is especially worrying because of the low growth that usually follows, persistent budget deficits, and rising liabilities due to ageing populations.  This can result in a downgrade of debt ratings and higher borrowing costs.

The IMF reviews 100 years of historical experiences of countries with high sovereign debt levels and the policies they used to make the necessary adjustments.  This is done in the third chapter of the World Economic Outlook (WEO) chapter 3 entitled The Good, the Bad, and the Ugly: 100 Years of Dealing with Public Debt Overhang (Sept. 2012).

There is widespread debate about the best way to reduce public debt. Some advocate strict budgets or fiscal austerity; others suggest growth through spending, or fiscal stimulus; and others cite the post–World War II U.S. strategy of “financial repression”—governments channeling funds to themselves.  The IMF research looks at the policy responses and outcomes in each case, and draws three lessons for countries battling high public debt today.

The first lesson is that fiscal consolidation efforts need to be complemented by measures that support growth: structural issues need to be addressed and with supportive monetary conditions.  The implications vary for countries dealing with high debt levels today. For some, such as the United States, where financial sector weakness has been addressed and monetary policy is supportive, it would suggest conditions are in place for fiscal consolidation. In others, such as the European periphery, where financial sectors remain weak and fundamental issues relating to monetary union remain unresolved, progress is limited.  Financial repression may not work for countries facing high debt burdens today. The consequences of historically low sovereign interest rates are unknown, but the inflationary consequences of financial repression could threaten the structures that have been in place in recent decades to prevent inflation.

A second lesson is that consolidation plans should emphasize persistent, structural reforms over temporary or short-lived measures. Belgium and Canada were ultimately much more successful than Italy in reducing debt, and a key difference between these cases is the relative weight placed on structural improvements versus temporary efforts. Moreover, both Belgium and Canada put in place fiscal frameworks in the 1990s that preserved the improvement in the fiscal balance and mitigated consolidation fatigue.

A third lesson is that fiscal repair and debt reduction take time—with the exception of postwar episodes, primary deficits are not quickly reversed. A corollary is that this increases the vulnerability to significant setbacks when shocks hit. The sharp increases in public debt since the Great Recession— including in the relatively successful cases of Belgium and Canada—exemplify such vulnerability.  Furthermore, the external environment has been an important contributor to past outcomes. The implications are sobering—widespread fiscal consolidation efforts, deleveraging pressures from the private sector, adverse demographic trends, and the aftermath of the financial crisis are unlikely to provide a favorable environment present in previous episodes of debt reduction. Expectations about what can be achieved need to be set realistically.

Based on these lessons, a road map for successful resolution of the current public debt overhangs is possible. First, support for growth is essential to cope with the contractionary effects of fiscal consolidation.  Policies must emphasize the resolution of underlying structural problems within the economy, and monetary policy must be supportive. Policy support is particularly important since all major economies must address public debt overhangs, and cannot always rely on favorable external conditions. Second, because debt reduction takes time, fiscal consolidation should focus on enduring structural change. In this respect, fiscal institutions can help. Third, while realism is needed when it comes to expectations about future debt trajectories and setting debt targets in a relatively weaker global growth environment, the case of Italy in the 1990s suggests that debt reduction is still possible even without strong growth.  The failure to control public debt growth can have costly consequences.

www.imf.org/external/np/tr/2012/tr092712.htm