Friday, February 12, 2010

Pass The Parcel

The wrapping fell off this one

OK, cue the music. The game works like this:
  1. individual and company players build up huge parcels of debt they can never pay off;
  2. the bank players who've lent the money to the individual and company players pass on the parcels as quickly as possible;
  3. the music slows down, and the bank players suddenly realise that they're now holding other people's parcels which they suspect are not worth anything like what it says on the label;
  4. there is a frenzy of parcel passing, until suddenly the music stops;
  5. the bank players realise they are still holding stacks of parcels, they have no idea which is which, and no idea what they contain;
  6. shrieking and general pandemonium: the bank players threaten to abandon the game unless somebody else takes the parcels away;
  7. the government players hastily step in and gather up all the parcels from the bank players and re-label them as government debt;
  8. the music starts again - a bit faster;
  9. with nobody else borrowing, the government players build up huge further parcels of debt - debt they can never pay off;
  10. the music slows down, and the market players who've lent the money to the government players suddenly realise that some of their government debt parcels aren't worth anything like what it says on the label;
  11. there is a frenzy of parcel passing, until suddenly the music stops;
  12. the market players find they are all still holding stacks of parcels; worse, some of the smaller  government debt parcels have started to tick;
  13. more shrieking and general pandemonium: the market players threaten to abandon the game unless somebody else takes the ticking parcels away;
  14. the biggest government players agree to take away the smaller government debt parcels and re-label them Big Government Debt; some players start edging towards the exit
  15. the music starts again - faster still
  16. the big government players suddenly realise they are holding all the other players' debt parcels, and there are now no other players to pass them on to; there is a general rush for the exit;
  17. the ticking gets a lot louder and horrified players realise the exit is locked;
  18. the music stops and the big government players start screaming that it's all someone else's fault and that anyone who's still got any money has got to hand it over in tax.

Something really horrible is underway: taxpayers in the big western economies are being stuffed with everyone else's bad debts. Here in Britain, we've already had to bail out the bankers, and now - whatever Darling may say - we're at risk of having to bail out the PIIGS.

Much more fundamentally, the longer the government borrows on the current humongous scale, the bigger the debt burden that will be loaded onto our backs for decades to come.

Now there are those who say right now we need the government to run a big deficit, because everyone else wants to run a surplus. That is to say, individuals and companies are slashing their spending in order to repay their own debts, and if government wasn't prepared to fill the gap, aggregate spending (aka demand) would collapse. You will recognise good old textbook Keynesianism.

But this argument overlooks a most incovenient truth. Which is that in the Keynesian textbook, government runs a temporary deficit to get the economy through a temporary (ie a cyclical) weakness of private sector demand. However, our current situation is that we're facing a permanent cut in private sector demand, reflecting a permanent cut in our GDP.

The cut comes about because around 6% of our GDP was wiped out by the collapse of the bubble and its associated jobs and profits (and 6% is HMT's figure - it could be higher). It will not return.

And what that means is that however much we might like to shore up demand in the economy, we simply don't have the necessary level of national income to support the current rate of government spending. Sure, in the short-term, the government can continue to fund it by borrowing 13% of our GDP. But at some unknown point - call it 24 hours after George delivers a weak budget in June - the cost of that funding will shoot up as the markets take fright.

Yesterday, money historian Niall Ferguson had an excellent piece in the FT describing the very real risk that deeply indebted America could head into a sovereign debt crisis every bit as bad as Greece's. As he says:
"Explosions of public debt hurt economies in the following way, as numerous empirical studies have shown. By raising fears of default and/or currency depreciation ahead of actual inflation, they push up real interest rates. Higher real rates, in turn, act as drag on growth, especially when the private sector is also heavily indebted – as is the case in most western economies, not least the US.
Although the US household savings rate has risen since the Great Recession began, it has not risen enough to absorb a trillion dollars of net Treasury issuance a year. Only two things have thus far stood between the US and higher bond yields: purchases of Treasuries (and mortgage-backed securities, which many sellers essentially swapped for Treasuries) by the Federal Reserve and reserve accumulation by the Chinese monetary authorities."
In terms of fiscal malaise, our situation is actually worse than the US. But Fergusson's piece highlights the global nature of the crisis. When the US catches a dose of higher bond yields - as it surely will - we will go down with a bout of double debt pneumonia.

Yes, I know - I'm getting my metaphors in a twist again. But frankly, that's not surprising - the grim prospect of double digit bond yields on our vast mountain of government debt is enough to twist anyone's metaphors.

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