"Bible code, finance edition
A financial lesson brought to us from way, way, back many centuries ago courtesy of HSBC’s chief economist Stephen King:
In the Bible, you can find everything you need to know about government borrowing. Joseph’s interpretations of Pharaoh’s dreams gave warning that feast would be followed by famine. In response, the Egyptian ruler ordered Joseph — by that stage the Biblical equivalent of a modern-day finance minister — to look after the nation’s grain supplies. Joseph stored enough grain to ensure that, when the inevitable downswing came, no one (his brothers included) would go hungry.
Accordingly, King presents the notion we may all be in for a bit more austerity than perhaps originally planned for. That’s mostly because, whatever the policymakers say, we failed to saved up in the good years and now the numbers don’t add up:At the very least, governments need to pursue a multi-year period of fiscal austerity. Even that, though, may not be good enough to stabilise the fiscal outlook. Credit booms tend to leave countries with permanent activity losses, undermining a government’s ability to raise revenues to support public services. And, even if productive potential were to be untouched by the crisis, governments still face problems. The number of higher rate tax payers will shrink in response to a diminishing financial sector. Ageing populations will place tremendous pressure on some governments to raise healthcare and pension outlays.
Of course, austerity is not the answer most politicians will be looking for; strategies for dealing with the crisis have tended to focus on capital injections, quantitative easing and fiscal easing and not the concept of increased frugality.
As King points out, however, these carry risks in themselves and have in some cases created simply dire fiscal situations:
Unless there is an early, strong and sustained recovery in economic activity — an unlikely scenario in our view — fiscal positions will become intolerable politically, economically and financially.
The worst of these cases is to be seen in the US and the UK, following years of large deficits and government debt levels rising to among the largest in the G6, King says.
Missed opportunities to save-up for rainy days now lead to six possible scenarios (our emphasis):
1) The rosy scenario, where above-trend growth actually transpires after all:
A closure of negative output gaps by 2020 but with no additional fiscal tightening above and beyond what is already spelt out in existing government plans. Above-trend growth persists over the next 10 years. This could be called the “rosy” scenario. Mostly, though, the fiscal numbers continue to deteriorate notwithstanding the faster growth rate.
2) The austerity scenario:
Sufficient fiscal tightening to stabilise government debt/GDP ratios by the end of the period, leaving output lower than in (1). This might be called the “austerity” scenario.
3) The Bad planning scenario:
A lowering of the level of economic activity relative to scenario (2) which, in effect, implies a permanent lowering of the longterm growth rate (a reduction, perhaps, from the “optimistic path” to the “true path”). No additional fiscal tightening is imposed on the model relative to (2). This might be labelled the “bad planning” scenario.
4) A deflation scenario:
A deflation scenario whereby central banks are unable to deliver their mandated goals and where the onset of deflation leads to a permanent lowering of growth through either Fisher-style or Keynesian deflation dynamics. This is an extension of (3) and represents a severe form of Japan’s experience during its lost decade.
5) A default scenario:
A default scenario, where the level of nominal interest rates on outstanding government debt rises sharply because of either the end of quantitative easing benefits, future inflation fears or, alternatively, because governments have no alternative but to suspend payments to existing creditors.
6) And lastly the printing press scenario:
A “printing press” scenario, whereby an increase in money supply used to purchase government debt leads to lower yields and higher inflation, thereby punishing bond holders via negative real interest rates. An overly low hurdle rate for investment, however, leads to inefficient resource allocation, leaving growth weaker over the medium term.
Of these, King says the austerity scenario is probably the best one to aim for. Sustained fiscal tightening for five or six years might just be enough to stabilise the debt/GDP ratio, albeit at a much higher level than it is now at. Pursuing this strategy, however, would have the most severe implications for the UK where the degree of tightening needed is greatest.
The risk, however, is that policymakers focus on the printing press scenario instead — interpreting it as the most helpful from a fiscal perspective in the short term. From all other angles, however, this would be a disaster says King: …on the assumption that capital is increasingly poorly allocated, the mix between growth and inflation steadily deteriorates, threatening a 1970s-style stagflation.
For the US and the UK in particular, the incentive to shift the burden elsewhere through monetised government borrowing and, hence, exchange rate depreciation is very high:
Whatever the case, it appears no solution will come with a free lunch:
…any improvement in the fiscal situation is likely to be limited in duration. For the US and, in particular, the UK the likely reduced share of financial services in GDP will limit future revenue growth for a given growth rate of the economy (the financial services industry includes a disproportionate amount of higher rate taxpayers).
Which leads King to conclude:
Yet our projections suggest that, aside from the most optimistic assumptions, the fiscal outlook is now very poor. So many countries are borrowing heavily, and so few were prepared to deliver significant fiscal consolidation during the earlier boom years. Something has to give. Even if output gaps close by 2020, the fiscal numbers for the US, Japan, France and the UK will not add up unless there is a bout of significant fiscal consolidation involving tax increases or public spending constraints. In the process, there are obvious risks, including an outbreak of deflation and an increase in the risk premium on government bonds, both of which would make the fiscal arithmetic even more painful.
Amish-style austerity certainly appears to beckon.