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October 26, 2009 2:53 pm
For nearly two decades, every credit crisis has been palliated with a further wave of leverage, kicking off a new economic cycle. Can this work again? I think not. In this post-credit crisis world, some things will be permanently different.
It will not be business as usual for government bond prices. That is because current bond yields and the increasing insolvency of our rulers are the biggest disconnect in financial markets today. This comes from two factors: quantitative easing by central banks and the collapse of credit demand by the private sector. Neither are permanent features of the economic landscape.
Some will note that, when Japan’s bubble economy collapsed, it was able to run huge budget deficits and raise outstanding government debt from 60 per cent to 140 per cent of gross domestic product, while still experiencing a fall in bond yields from 8 per cent to 1 per cent.
But this “miracle” was only possible because Japan’s household savings were huge and invested at home. Japan did not need foreigners to fund its government deficits. Even today, foreign ownership of Japanese debt is only 6 per cent compared with 50 per cent for US government paper.
But Japan’s household savings rate has collapsed due to an ageing population who no longer save. This low saving rate is something death must undo, not the politicians or monetary policy. So, if Japan is now running budget deficits at double- digit percentage rates of GDP, it can no longer use low-cost excess domestic savings to do so.
The Japanese “miracle” of the 1990s cannot be repeated in the US, the UK or even in Japan this time. The US and the UK will still have very low domestic savings rates with government debt heading towards 100 per cent of GDP. Neither is likely to suffer from prolonged deflation as Japan did. And both the US and the UK are heavily dependent on foreigners for financing that debt. So Treasury and gilt yields will rise sharply and the dollar and the pound will slide.
Moreover, for the first time in postwar history, Japan will be feeding at the same trough of global savings as the US and the UK. An unprecedented 25 per cent of current global savings will be sucked up by government debt financing for nations in the Organisation for Economic Co-operation and Development. That will crowd out productive investment and bodes ill for inflation down the road.
As the US, UK and Japan will be trying to borrow the same buck in international markets, bond yields will rise when QE stops and there is an even modest recovery in credit demand from the private sector. That alone is enough to prevent the development of a new credit bubble similar to those that have been economic drivers for nearly two decades. All credit bubbles rely on underpriced capital being in oversupply relative to the fundamental needs of an economy. Given the huge demand for capital by increasingly insolvent governments, those conditions won’t exist.
When will the bond bubble burst? During the current risk rally, central banks have been pumping liquidity into banks to the tune of 6-8 per cent of GDP. Instead of lending this money onto the real economy, banks have either hoarded it in excess reserves or invested it in government bonds. Risk-averse individuals have also been piling into government bonds. That keeps everyone happy: the politicians get cheap money, the commercial banks make money and the central banks keep the system liquid.
But quantitative easing programmes will have to end sooner or later; and eventually the private sector will start to borrow again. Then yields on government debt will start to rise, back towards at least the average level of the 1990s and perhaps even higher as inflation expectations gain hold. That will end today’s bubble in bond markets and very probably in equity markets too, as these feed on the same source of liquidity and are priced off bond markets by the addition of a risk premium.
This necessary repricing of capital will prevent the recurrence of a bubble economy. The danger for the real economy is not that the return to a normalised monetary policy takes place but that it does so too late. Too late would mean that the fall in asset prices has to be so large that it skittles economic recovery.
The writer is is president of Independent Strategy, a global investment consultancy
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