Global panic subsides, but what’s next?

It has been a better month for the global economy.

This will encourage the Reserve Bank to hold monetary policy where it is for another month at least.

Financial markets are in better shape with reductions of credit ‘spreads’, no fresh news of major banks in trouble and equity prices continuing their now quite strong recovery, albeit with equity prices still well below their previous peaks.

Central bankers generally are delivering more soothing messages and their smiles seem less forced.  Fiscal expansion is now in place virtually everywhere and commodity prices have risen as stories increase about the effectiveness of China’s stimulus package in particular.

Experts on the oil market say there could be a new ‘peak oil’ price above US$150 per barrel in the next year or two as demand recovers.  This is because oil supply is falling while major nations, especially the USA, have so far done little to introduce alternative, renewable, energy sources.

So is the world facing an unalloyed cheery perspective?  Unemployment everywhere is climbing and will continue to do so for some time yet.  The US housing market remains in dreadful straits, although US consumer confidence has rebounded slightly. 

The UK has been rocked by a parliamentary rorts scandal to add to its more traditional economic woes, which themselves are rivalling the USA’s economic pain.

The shadow of Eastern Europe’s bad debts hangs over Western Europe’s banks.

The big risk to sustained recovery still centres on the state of the global financial system.

John Taylor (of ‘Taylor rule’ fame) has recently written in the Financial Times that ‘Exploding debt threatens America’.

‘Under President Barack Obama’s budget plan, the federal debt is exploding. To be precise, it is rising – and will continue to rise – much faster than gross domestic product, a measure of America’s ability to service it. The federal debt was equivalent to 41 per cent of GDP at the end of 2008; the Congressional Budget Office projects it will increase to 82 per cent of GDP in 10 years. With no change in policy, it could hit 100 per cent of GDP in just another five years.

“A government debt burden of that [100 per cent] level, if sustained, would in Standard & Poor’s view be incompatible with a triple A rating,” the risk rating agency said last week.

Taylor adds: ‘I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis’.

The problem is that America is facing trillion dollar deficits as far as the eye can see.

Reducing the debt ratio back to 41 % would require massive tax increases or very substantial inflation.  Taylor calculates either tax rates would have to increase by 60 % across the board –which would be very damaging for real economic activity – or GDP would have to double, meaning inflation would have to average 10 % per annum for 10 years – also very damaging for the ‘real’ economy.

‘The fact that the Federal Reserve is now buying longer-term Treasuries in an effort to keep Treasury yields low adds credibility to this scary story, because it suggests that the debt will be monetised. That the Fed may have a difficult task reducing its own ballooning balance sheet to prevent inflation increases the risks considerably. And 100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar’.

Standard and Poor has downgrade its outlook for British sovereign debt from “stable” to “negative”, and this agency will no doubt be thinking of the same change for the mighty USA.

As we have been told many times, the Australian economy is in far better shape that of the UK or USA.

Official debt is currently expected to rise to ‘only’ $300 billion as a result of the large budget deficits currently predicted.  Of course, if the recession is worse than now expected, or if recovery is slower, this number could well be larger.

This caveat aside, the comforting fact of a relatively small official debt is greatly complicated by the approximately $ 700 billion of private debt, much of this owed by Australia’s banks.

While adding the $300 billion of official debt to the, say, $800 billion of private debt that will be owed in the next two or three years is excessively simple, it does serve to illustrate that Australia also has a serious problem of excessive debt.

Official debt arises because the government spends more than it earns.  Private debt arises because the private sector spends more than it earns.

Some of the private debt has funded useful investments and can be called ‘good debt’.  Much of it financed a massive housing and consumption boom and is far less benign.

All three ‘Anglo’ economies are facing a serious choice.  Australia, the UK and the USA need to curb their propensity to spend more than they earn (except when the overspending is for investments that yield high returns).  This would involve a period of austerity and a return to the traditional values of restraint and self-sufficiency that helped make the Anglo nations so strong.

Or we can avoid the pain and trouble of seeking to live within our means, and continue to fund spending in excess of production with a mix of new debt and inflation.

With the UK and the USA, we are currently following the low road of business as usual.

Here is my prediction.

We may scrape through this episode with business as usual more or less intact.

But, if we do, a larger crisis awaits us within the next decade.

Then we shall face the urgent need to reform our mind-sets with a return to traditional values of thrift, hard work, self-reliance and encouragement of entrepreneurial flair.

Published today in The Australian.