A Hard Fight From Here . . .

Economic Hangovers From the Debt Binge

The IMF has just published its latest Global Financial Stability Report. It makes explicit what we have always known, ever since the Great Credit Crunch of 2008. The past two years have seen a massive transference of risk from the private, non-government sector to the public or government sector.

All over the world governments have "bailed out" their banks, commercial enterprises, and households. The term "bailed out" is really misleading, because all that has occurred is that liability and debt has been transferred from private sector balance sheets to the balance sheets of governments, which in the end will be paid for by those same households and businesses (or at least their successors). The debt will be paid either through inflation or taxation or both. But, according to the IMF, the expansion of debt on sovereign balance sheets is not going to lessen any time soon.

But the biggest threats have moved from the private to the public sectors in advanced economies. Governments not only took on many of the bad assets from private institutions but due to the recession face continuing heavy borrowing needs for the next few years. Slow growth in the real economy and high unemployment will retard tax revenues and require higher government spending—such as on unemployment benefits and job creation activities.

“In spite of recent improvements in the outlook and the health of the global financial system, stability is not yet assured,” Viñals said a news conference April 20. “If the legacy of the present crisis and emerging sovereign risks are not addressed, we run the very real risk of undermining the recovery and extending the financial crisis into a new phase.”

For the present, the risks have passed over the banks to governments, and banks have survived. So risks of systemic bank collapse have been avoided for the present. We can all breathe easier. Or can we?

Improving economic and financial conditions have helped private bank balance sheets in advanced economies. The IMF sharply reduced its estimate of the writedowns or loan loss provisions banks will have to take—or have taken—to account for bad loans and securities on their books. The improving quality of bank assets means that banks will probably need less capital than previously estimated to absorb losses. But banks still will face funding difficulties in the next few years, as their bonds mature and the special government assistance programs are withdrawn.

Two problems will persist over the next few years, according to the IMF. Firstly, the vast expansion of government will inevitably crowd out the private sector's innovation, efficiency-on-the-ground, and access to inexpensive capital. Governments will be soaking up more and more capital to fund their bail-outs, borrowings, and increased spending. There is a world of productive difference between borrowing to expand a business, on the one hand, and borrowing to fund the life-style of entitlement classes, on the other.

The IMF warned that the increase in sovereign risk can hit banking systems and the real economy that produces goods, services, and jobs. Even with weaker private credit demand, governments could crowd out business and household borrowers, retarding recovery.

Secondly, bank lending to the private sector is going to remain subdued for several years to come. This is because banks are continuing to write off bad assets, improve their balance sheets, rebuild capital reserves, and pay back their government loans. Moreover, interest rates are going to rise due to governments competing to borrow more and more money to fund their deficits. What most people don't realise is that banks usually make more money in low interest rate conditions, than higher. Thus, not only will banks not be lending as much, they will make less on what lending is undertaken.

Although the worst of the credit contraction may be over, banks are unlikely to boost lending substantially in the near term—both because of the continuing overhang of bad assets that remain on their books and the funding pressures they will face. Moreover the withdrawal of the special government support will further constrain bank lending.

Although private credit demand remains modest—households and businesses continue to reduce their debt levels—sovereign borrowing threatens to overwhelm it, potentially driving up interest rates, forcing private demand to shrink, or both.

What are the implications? Economic recovery in New Zealand is likely to be anaemic. Tax revenues will remain subdued--risking longer, more protracted fiscal deficits. A foresighted and smart government would take an axe to government spending, would curtail payments to the entitled classes, would sell off commercial enterprises owned by the state, and would do all within its power to reduce deficits. At the same time, smart government would systematically drive down tax rates to encourage activity in the productive economy. We will see just how smart the present National government is come next election.

The housing sector--that long favoured engine for debt fuelled enrichment--will likely remain subdued for several years, unless immigration sharply increases, pushing up demand for houses. Household debt reduction is likely to continue, particularly as interest rates rise.

All in all, if the IMF is right, the next five years in New Zealand are likely to be the economic equivalent of a prolonged enervated weakness due to lingering fevers and infections--sort of like a national economic equivalent of Tapanui Flu. But, at a micro-level, well capitalised businesses, with sound (but not flashy) leadership, with good cash flows are likely to do very well, thank you. However, the get-rich-quick, flash Harry, golden chained, mover and shaker types that used to frequent the Ponsonby and Parnell bars, boasting of their latest deal are likely to become an extinct species.

Hopefully our political representatives at central and local government levels will get the message. The last thing we need is politicians with "visionary" ideas, promising to create "Party Central" on decrepit wharves. If President Reagan was right, and the most dangerous sentence in the English language is, "I'm from the government, and I'm here to help," surely the second most dangerous must be, "I'm from the government and I have a really big bright idea."