The Global Debt and Financial Crisis Risk

The Global Debt and Financial Crisis Risk
Carlos M Pelaez

The most critical vulnerability of the world economy is the risk of the combination of a global debt event with another financial crisis. The objective of this comment is to analyze this risk by considering below the major aspects of the (I) global government debt and bank crisis, the contribution to the shock by (II) the Senate bank regulation risk of financial crisis, the analysis of (III) economic recovery and (IV) conclusions.
I Global Government Debt and Bank Crisis. There is an explosion of sovereign risk mixed with bank exposures across frontiers that may dominate all events in the world economy. The current World Economic Outlook of the International Monetary Fund provides estimates of the fast increase of the government debt as percentage of GDP for advanced economies from 2008 to 2015: Canada 22.6 to 30.4, France 57.8 to 85.1, Germany 59.3 to 74.8, Italy 103.9 to 122.1, Japan 96.9 to 153.9, United Kingdom 45.5 to 83.9, United States 47.2 to 85.5 and Euro Area 59.5 to 84.9 (http://www.imf.org/external/pubs/ft/weo/2010/01/pdf/text.pdf ). The IMF states that “without more fully restoring the health of financial and household balance sheets, a worsening of public debt sustainability could be transmitted back to banking systems or across borders” (http://www.imf.org/external/pubs/ft/gfsr/2010/01/pdf/summary.pdf ). The IMF has had significant experience in resolving the interaction of debt crises with the delicate web of interbank credit lines. Banks with exposure of interbank credit lines to other banks in the debt crisis country do not renew short-term credit and short country risk to diminish their exposures in avoiding hits to shareholder wealth (Pelaez and Pelaez, International Financial Architecture, 186). The Fed has issued guidance on the management of interbank financial liabilities (http://www.federalreserve.gov/newsevents/press/bcreg/20100430a.htm ). There are available currency, interest and credit default derivatives to buy protection or insurance against default of credit to the government, entities or individuals in the country with unsustainable debt (Pelaez and Pelaez, International Financial Architecture, 134-54, Globalization and the State, Vol. I, 78-99, Government Intervention in Globalization, 57-63, 70-4). The mechanisms of risk management to diminish exposures to subprime mortgages were similar. In both cases the original cause was also similar: excessive budget deficits in the country with unsustainable debt and excessive mortgages with lax credit standards in the US originating in a long period of low interest rates with 1 percent fed funds rates in 2003-2004, artificial lowering of mortgage rates by elimination of auctions of 30-year Treasuries, housing subsidy of $221 billion per year and purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). In both cases, defensive risk management in the form of buying insurance against loss of net worth is erroneously alleged as a cause: (i) “speculative attacks” against a nation by shorting its debt and currency when even the nationals exit the currency to save their net worth; and (ii) sophisticated short derivative transactions by banks, financial institutions and even personal wealth portfolios to reduce heavy losses in exposures to mortgages. Banks in the larger economies in Europe have exposures to the countries with economies of smaller dimension but significant combined aggregate size that could be hurt in country debt defaults (http://professional.wsj.com/article/SB10001424052748704423504575212323413641634.html?mg=reno-wsj ). The European Central Bank (ECB) is finding a different balance sheet risk. Loans to indebted countries that could be collateralized with the debt of those countries could lose value in default events, causing losses to the portfolio of the ECB (http://professional.wsj.com/article/SB10001424052748703832204575210334213031028.html?mg=reno-wsj ). A central bank could be in risk similar to that of a collateralized debt obligation (CDO) referenced to nonprime debt, formerly AAA-rated debt in the case of the central bank and formerly AAA-rated mortgages in the case of mortgages. Evidently, credit ratings and credit decisions are not characterized by perfect foresight. The flaw of attributing the crisis to banks is also evident here: who could have thought that AAA-rated sovereign debt securities would default? Low interest rates, Fannie and Freddie created the illusion of permanently rising real estate prices such that even nonprime loans could be saved by selling foreclosed property without a loss.
The issue of global imbalances was considered in academic literature and in research by the IMF as joint occurrence of domestic fiscal deficits together with external or current account deficits. An important aspect of the theoretical and empirical analysis of global imbalances is the difficulty posed by the aging population in mature economies in Europe and Japan in the adjustment of fiscal deficits and government debts while increasing productivity to remain competitive (Pelaez and Pelaez, The Global Recession Risk, 109-11, 135-44). Depending on the assumptions, the US is more or less years away within the current decade of government debt around 100 percent of GDP. The problem of entitlements is also critical in the US. The Medicare Board of Trustees calculates under its “budget perspective” present-value net deficits of $45.8 trillion in the next 75 years from Medicare and Old Age, Survivors and Disability Insurance (OASDI) or Social Security that are equivalent to 5.8 percent of the present value of the GDP in that period of $791 trillion (http://www.cms.gov/ReportsTrustFunds/downloads/tr2009.pdf ). The Medicare hospital insurance or Part A trust fund will be exhausted by 2017. The solution to the Medicare financial imbalance could require gradual or immediate increases in the payroll tax from the current 2.90 percent to 6.78 percent equivalent to an increase of the tax by 134 percent or reduction of expenditures by 53 percent. The OASDI Board of Trustees predicts that annual costs will be higher than income by 2016 and that the OASDI trust fund could be exhausted by 2037 (http://www.ssa.gov/OACT/TR/2009/tr09.pdf ). States face unfunded entitlement liabilities while experiencing substantial budget deficits. Chairman Bernanke summarizes the risks: “Increasing levels of government debt relative to the size of the economy can lead to higher interest rates, which inhibit capital formation and productivity growth, and might even put the current economic recovery at risk. Moreover, other things being equal, increased federal debt implies higher taxes in the future to cover the associated interest costs—higher taxes that may create disincentives to work, save, hire, and invest” (http://www.federalreserve.gov/newsevents/speech/bernanke20100427a.htm ). The most important fiscal imbalance and debt sustainability issues that can jeopardize the immediate future are bypassed in the effort to restructure the economy. Successive unfavorable short-term adversities may reverse any of the alleged long-term benefits of the restructuring legislation.
II Bank Regulation. There are two major issues relating to the Senate Financial Stability Act (SFSA) being debated in Congress to regulate banks: the allegation that the SFSA would have prevented the credit/dollar crisis and global recession and the risk that the SFSA may create another financial crisis. First, Origins of the Credit/Dollar Crisis. The credit/dollar crisis did not originate in insufficient bank and financial regulation but rather in monetary policy that is a form of regulation. Thus, the credit/dollar crisis and global recession would have been avoided by different government policies instead of simply by draconian controls of banks and financial institutions as proposed by the SFSA. The official conventional story is that monetary policy was perfect but that greed, irresponsibility and “unfettered” free markets caused the debacle. The release of the Federal Open Market Committee (FOMC) transcript of May 4, 2004, is being analyzed in terms of the reasons behind the decision to increase interest rates by 25 basis points (bps) in 17 consecutive FOMC meetings from 1 percent in Jun 2004 to 5.25 percent in Jun 2006. The argument is that the 25 bps increments during a prolonged period actually encouraged the creation of excess credit in the economy such as the boom in mortgages that fueled house prices (http://professional.wsj.com/article/SB10001424052748703871904575216242106011222.html?mod=wsjproe_hps_LEFTWhatsNews ). Members present at the FOMC meeting on Dec 14, 2004, expressed the view that the low interest rates by the Fed had encouraged mortgages at low rates that fueled house prices (http://www.bloomberg.com/apps/news?pid=20601087&sid=asN.6J4RCnOo&pos=3 ) The transcripts of the May 4, 2004, meeting reveal that the motivation for the small doses of 25 bps increases over a prolonged two-year period originated in reflections by then Chairman Greenspan of an earlier episode: “When I say ‘move,’ I mean by 25 basis points. I mention that partly because of the experience of February 1994. Those of you who were here then may remember that there was a groundswell opinion within the Committee in favor of moving rates up not 25, but 50 basis points. And I went berserk for the first time and, I hope, the last time at an FOMC meeting, on the ground that, whatever we did, the markets were going to respond fairly exceptionally, which in fact they did. So, on the basis of that particular history, I would say that we should not move more than 25 basis points in June” (http://www.federalreserve.gov/monetarypolicy/files/FOMC20040504meeting.pdf ). Stress tests of banks use parameters of the bond market crash in 1994, which started in the US by the tightening of the fed funds rate from 3.00 percent in Feb 1994 to 6.0 percent in Dec 1994 (Pelaez and Pelaez, International Financial Architecture, 114-5, The Global Recession Risk, 206-7). The yield of the US 30-year Treasury bond increased by 150 basis points, causing declines in bond prices because increases of yields of 100 basis points caused declines of prices of 13 percent, which were magnified by typical leverage of 10:1. There was an increase in 30-year mortgage rates of 200 basis points that caused the loss of most of the value in funds of asset-backed securities. Europe was lagging the business cycle in the US and bond strategies consisted of long positions in higher-yielding markets that eventually also turned sour. Traders with long leveraged fixed-income and derivatives exposures waited for decoupling of European bond prices that continued declining during 1994. The correlation of bond yields of the US, European Union and Japan was only 0.18 and that of equities 0.40. Available statistical models failed to capture the much higher fed-tightening event correlation of fixed income and equities used in subsequent stress tests much the same as changes in correlations and effectiveness of hedge ratios caused by flight out of risk during the Long Term Capital Management (LTCM) event in 1998, converting LTCM’s hedged position into a short naked option (Philippe Jorion cited in Pelaez and Pelaez, The Global Recession Risk, 12-3). The Mexican crisis of 1994 was significantly influenced by the flight from risk and duration caused by the doubling of the policy rate by the Fed in 11 months, causing shocks in Argentina and Brazil. The 1994 episode resembles the increase of the fed funds rate from 1 percent to 5.25 percent from Jun 2004 to Jun 2006 that had strong effects on the credit quality of mortgages. The strength of labor and financial markets and the real economy were not major factors of fed policy. In the increase of rates in 1994 the Fed was concerned with inflation originating in commodity price increases that failed to spread to general prices. In the increase after Jun 2004 the Fed was escaping the 1 percent interest rate and forward guidance after deflation also failed to materialize, which was an important determinant of the credit/dollar crisis and global recession (Pelaez and Pelaez, The Global Recession Risk, 207, 221-5, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The fed has been managing monetary policy with aggressive changes in interest rates based on the view of the economy and financial markets six months ahead. There may not be sufficient knowledge about central bank policy for controlling the effects of these wide swings in monetary policies (Pelaez and Pelaez, Regulation of Banks and Finance, 108-112, Financial Regulation after the Global Recession, 74, 84-6, International Financial Architecture, 230-7). In the meeting of May 4, 2004, the Fed was beginning to realize the excessive credit stimulus that it had created by lowering the fed funds rate to 1 percent for one entire year from Jun 2003 to Jun 2004, issuing a guidance that rates would remain as low as required and commenting in speeches that low rates were required to avoid catastrophic deflation as it had occurred in Japan and during the Great Depression (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm cited in Pelaez and Pelaez, The Global Recession Risk, 93). There is no scientific/painless exit from the Fed balance sheet portfolio of $1.98 trillion of long-term securities as of Apr 28 (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) and the 0-1/4 percent fed funds rate. The combination of unwinding the portfolio of $1.98 trillion and raising the fed funds rate may not be orderly even with new instruments (http://www.federalreserve.gov/newsevents/press/monetary/20100430a.htm ) especially in a troubled global debt and financial environment. What are the painless or optimum timing, dose and speed of fed funds rate increases?
Second, Senate Bank Regulation Risks of Financial Crisis. The SFSA regulation of banks can cause another stressful environment for banks in two general forms that could trigger another financial crisis. (1) The SFSA restricts diversification of banks into different lines of activities, concentrating transactions in credit. Less diversified banks are more vulnerable because certain revenues, such as trading currently, compensate for write downs, such as the tail of loan losses from the credit crisis. The SFSA creates a consumer protection agency that will drive investors away from the stocks of banks engaged in consumer credit subject to arbitrary regulatory sanctions and restriction of profits. The consumer will also experience lower credit volumes at higher interest rates as with the CARD (Credit Card Accountability and Responsibility Act) of May 2009. The Volcker Rule would deprive banks of revenues from trading and managing hedge funds and private equity funds that have never posed problems in earlier crisis, again concentrating transactions in riskier lending. The derivatives provisions of the SFSA would cause the spinning of swap desks of banks. An important result of the SFSA will be the migration overseas of these banks activities and the resulting weakening of the competitiveness of US banks relative to foreign banks that will hurt trade and global operations of US companies. (2) Much the same as what is revealed in the transcripts of FOMC meetings will happen with the systemic risk oversight council: lack of knowledge on what to do with regulatory powers. Banks that are viable in their present form may not be viable when dismembered of lines of business. The financial system may suffer crisis stress when the dismembering or even closing of one bank affects other banks that are large, medium or small and even the entire financial system. Amputations of business lines of key players in the financial system without precise science may well trigger the “systemic” crisis that the SFSA intends to prevent. Turmoil in financial markets and bank stocks in the preceding week created unpleasant memories of declines of stock prices of large financial institutions toward zero.
III Economic Recovery. US GDP increased for a third consecutive quarter at a seasonally annualized percentage rate of: IQ10 3.2, IVQ09 5.6 and IIIQ09 2.2 (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp1q10_adv.pdf ). GDP declined by 2.4 per cent in 2009 after increasing by 0.4 percent in 2008 and 2.1 percent in 2008. The credit/dollar crisis and global recession after 2007 is typically exaggerated as the “worst” financial and economic crisis since the Great Depression of the 1930s. Comprehensive review of the vast literature on the Great Depression reveals a contraction of output and employment that was immeasurably stronger than the world contraction in 2008-2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 197-217). The decline in real or price adjusted GDP in 1930-1933 accumulated to 26.7 percent and 45.5 percent in current dollars or without adjusting by price changes (Pelaez and Pelaez, Financial Regulation after the Global Recession, 151). There was significant improvement in the driver of growth in IQ10 relative to IVQ09 revealed by the contribution in percentage points (pp) to the growth rate: personal consumption expenditures 2.55 pp in IQ10 versus only 1.16 pp in IVQ09, services 1.15 pp in IQ10 versus 0.49 pp in IVQ09and change in private inventories only 1.57 pp in IQ10 versus 3.79 pp in IVQ09. Net exports of goods and services contributed -0.61 pp in IQ10 versus 0.27 pp in IVQ09 and government -0.37 in IQ10 pp versus -0.26 in IVQ09. Demand instead of inventory reduction was the driver of GDP growth. The growth of GDP from the same quarter a year before of 2.5 percent in IQ10 was much higher than 0.1 percent in IVQ09, and the highest change since 1.6 percent in IIQ08. Personal consumption expenditures increased by 1.8 percent in IQ10 relative to a year earlier and gross private domestic investment by 7.7 percent for the first increase since IIIQ06. The percentage decline of gross private domestic investment exceeded 25 percent in the first three quarters of 2009 relative to the same quarter a year earlier. The Chicago purchasing managers’ business barometer increased for the seventh consecutive month by 5 points, reaching 63.8, which is the highest reading since Apr 2005 (https://www.ism-chicago.org/chapters/ism-ismchicago/files/ISM-C%20April%202010.pdf ). Seasonally adjusted initial-claims of unemployment insurance for the week ending Apr 24 decreased by 11,000 to 448,000 from the revised 459,000 in the previous week. Insured unemployment was 4.654 million in the week ending Apr 17, declining by 18,000 from the prior week’s 4.663 million (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
The failure to address the budget deficit and debt except probably by national value added and energy taxes to be considered after November could prevent the growth impulse required for alleviation of the plight of 26 million people in job stress. In the recession of the 1980s the quarterly annual percentage rate of growth of GDP was: -7.9 QII80, -0.7 QIII80, 7.6 QIV80, 8.6 QI81, -3.2 QII81, 4.9 QIII81, -4.9 QIV81, -6.4 QI82, 2.2 QII82, -1.5 QIII82 and 0.3 QIV82. During the recovery phase GDP grew at the quarterly annual percentage rate of: 5.1 QI83, 9.3 QII83, 8.1 QIII83, 8.5 QIV83, 8.0 QI84, and 7.1 QII84 and thereafter at rates in excess of 3 percent. Change in private inventories was a significant contributor to the rate of GDP growth in terms of percentage points only in a few quarters: 3.5 QII83, 3.1 QIV83 and 5.1 QI84. Growth was driven by personal consumption expenditures and fixed investment. The rate of unemployment increased from 6.3 percent in January 1980 to a peak of 10.8 percent in December 1982, declining at year end to: 8.3 percent in 1983, 7.3 percent in 1984 and 7.0 percent in 1985 (http://data.bls.gov/PDQ/servlet/SurveyOutputServlet ).
IV Conclusion. The recovery of full employment depends on sustained high quarterly annual rates of growth of GDP originating in demand and fixed investment. However, those rates may be restricted by taxation and higher interest rates. Exploding budget deficits and government debt may lead to higher taxation and interest rates that will stall economic recovery and relief to 26 million people suffering job stress. Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10