Repair and Reform the Only Way to Growth


(B) Last week, Chairman Ben Bernanke signaled that the current Feds’ program of bond purchases of $85 billion a month (or QE – quantitative easing forever) will slow later this year, and should end by the middle of 2014, if the US economy finally achieves the sustainable growth the Fed has sought since the recession ended in 2009. Short-term: this has obviously caused bond yields around the world to jump – medium/long-term: this will impact government debts which are already a major Black Swan in particular for Japan and the US. Printing money has definitely kept the growth of the US economy above stagnation, avoided the disintegration of the European Community, and boosted the equity markets.

This week, the Bank for International Settlements (BIS) issued its annual report which clearly outlines the limits of the Central Banks actions around the world:

“Central banks cannot repair the balance sheets of households and financial institutions. Central banks cannot ensure the sustainability of fiscal finances. And, most of all, central banks cannot enact the structural economic and financial reforms needed to return economies to the real growth paths authorities and their publics both want and expect.

What central bank accommodation has done during the recovery is to borrow time – time for balance sheet repair, time for fiscal consolidation, and time for reforms to restore productivity growth. But the time needs to be used wisely, as the balance between benefits and costs is deteriorating.

A return to growth calls for a different mix of policies: Authorities need to hasten labor and product market reforms so that economic resources can shift more easily to high-productivity sectors. Households and firms have to complete the difficult job of repairing their balance sheets, and governments must intensify their efforts to ensure the sustainability of their finances. Regulators have to adapt the rules to a financial system that is becoming increasingly interconnected, and complex and ensure that banks have sufficient capital, and liquidity buffers to match the associated risks. Each country needs to tailor the reform agenda to maximize its chances of success without endangering the ongoing economic recovery. With others doing their part, central banks will be able to normalize monetary policy.”

Last year, in a great speech delivered at the Council on Foreign RelationsRay Dalio of Bridgewater Associates did a magnificent job to explain us how governments can exit the burdens of debts by what he calls: a beautiful deleveraging where governments are willing and able to balance inflation (as a result of printing money) with deflation (as a result of writing down debts and implementing austerity measures).  Mr. Dalio explains extremely well the pains for governments to restructure their debts.

Also, the following from Mr. Dalio is a little bit longer, it is worthwhile to read and read again:

“A depression is the phase of the deleveraging in which there’s a combination of austerity and debt restructuring because if you have — it’s a basic thing If you have too much debt to service, you’ve got to do something about it. And when you have too much debt to service and you do something about it, there are a limited number of things that you can do. You can either transfer the debt, that you can transfer resources from the rich to the poor so you can have it transferred, for example, from Germany to Spain. That’s one way of dealing with it.

The other way is to — you have a combination of austerity and debt restructuring. A debt restructuring means that you lower the debt in one fashion or another; you lower the debt burden to something that you can afford to service because of the income that you produce. Restructuring can take one of three ways. You can either actually write down the debt. If you write down the debt, let’s say write it down in half because you can service half, you can service half, but the problem is, one man’s debts are another man’s assets. So when you write it down in half, you have a big negative wealth effect. So if you have a negative wealth effect, you can’t borrow money and it has that problem.

So a restructuring becomes a problem. You could restructure it either in the form of writing it down or in one way or another you can lengthen the payments or you can forcibly lower the interest rate. But some way or another, you’ve got to get the payments in line for what the cash flows are producing so that you can service that kind of debt. That’s a very painful process.

So depression is the phase of the deleveraging when there’s a combination of austerity and writing down debts. So, classic, the Depression, 1930 to 1932, March of 1933 we print money. So the third way that you can deal with it is you can print money, essentially what we call “print money.” The printing of money means that essentially a central bank — debt is a commitment to deliver the money. So if a central bank slips into the system a certain amount of money each year, it can make that easier.

Think about the debt write-down, that something maybe is debt and you say, I’m going to write it down to a level that can be sustainable, and you write it down by 50 percent. That has a big negative wealth effect. Big deal. Bad. If it’s a 10-year debt, maybe that’s equivalent to 5 percent a year for 10 years. If you slip in 5 percent a year instead to that person, who then can pay that debt, they can service the debt — it’s 5 percent a year — it’s not that big a deal. And so in all deleveraging, in the end, they print money. It’s part of the mix.

Now, the best deleveraging are ones in which you have a balance of those things. Ultimately, you have to bring down the debt-to-income ratio. So — and the ways that — ultimately, you’ll have a balance of those three things. Those three things, again: You’re going to have a certain amount of transfer of wealth; you’re going to have a certain amount — let’s call them four things — a certain amount of austerity, a certain amount of debt write-downs and a certain amount of printing of money.

The debt write-downs and the austerity are deflationary. The printing of money is inflationary. If you can get the balance right of those things, then you have what I call a beautiful deleveraging!”

 BIS 83rd annual report
 CEO Speaker Series: A Conversation with Ray Dalio
 A Silicon Valley Insider, “The Public Debts of the Developed Nations Could Well Lead to the Next Financial Crisis“, March 28, 2010
 A Silicon Valley Insider, “Too Big to Fail“, June 28, 2009

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Categories: Financial Markets