The Age of Stagnation

Chinese Growth is Bad for Global Economy

china

In yesterday’s edition of the Diary I talked about how Chinese banks have unleashed another round of easy money, in order to push up economic growth. The Chinese economic growth for 2015 was at 6.9% which is a two-decade low. Many China watchers and economists believe that the real economic growth is significantly lower than this number and is likely to be more in the region of 4-5%.

In order to push up economic growth Chinese banks lent out a whopping 2.5 trillion yuan (around $385 billion) in January 2016, the highest they ever have during the course of a month. This increased borrowing and spending if it continues, as it is likely to, will lead to creation of more capacity in China.
The creation of this excess capacity will provide a short-term fillip to the Chinese economic growth as more infrastructure, homes and factories get built. The trouble is that the Chinese economy is unlikely to absorb the creation of this excess capacity.

As Satyajit Das writes in The Age of Stagnation: “China continues to add capacity to maintain growth. If it is unable to absorb this new capacity domestically, it might seek to increase exports to maintain production and growth. This would exacerbate global supply gluts and increase deflationary pressures in the global economy.” Deflation is the opposite of inflation and essentially means a scenario of falling prices.

Household consumption as a proportion of the Chinese economy has fallen over the years. In 1981, household consumption made up for 51.7% of the gross domestic product(GDP). Starting in 1990, the household consumption as a proportion of the Chinese economy started to fall and by 1999, it was at 45.6% of the GDP.

By 2009, the number had fallen to 35.3% of the GDP. In 2014, the household consumption to GDP ratio stood at 36.6%, not very different from where it was in 2009.

What does this tell us? As Michael Pettis writes in The Great Rebalancing—Trade, Conflict and the Perilous Road Ahead for the World Economy: “In any economy there are three sources of demand—domestic consumption, domestic investment, and the trade surplus—which together compose total demand, or GDP. If a country has a very low domestic consumption share, by definition it is overly reliant on domestic investment and trade surplus to generate growth.” Trade surplus is essentially the situation where the exports of a country are more than its imports.

This is precisely how it has played out in China. In 1981, the Chinese investment to GDP ratio was at 33%. In 2014, the number stood at 46%. What does this tell us? By limiting consumption, the Chinese were able to create savings. These savings were then diverted into investments and the investment created excess capacity in the Chinese economic system. In 1982, the Chinese savings had stood at 35% of the GDP. By 2013, Chinese savings had jumped to 50% of the GDP. The investment to GDP ratio during the same year stood at 48%.

The excess capacity was taken care of by exporting more. And that is how the Chinese economic growth model worked all these years. What this means that with a low consumption rate, the Chinese have always been more dependent on investment and exports to create economic demand. In the 1980s and 1990s, the high rate of investment made immense sense, when China lacked both infrastructure as well as industry. But over the years China has ended up overinvesting and creating excess capacity, and in the process become overly dependent on exports, if it wants to continue to grow at a fast rate.

As Pettis writes: “With consumption so low, it would mean that China was overly reliant for growth on two sources of demand that were unsustainable and hard to control. Only by shifting to higher domestic consumption could the country reduce its vulnerability and ensure rapid economic growth. This is why in 2005, with household consumption at a shockingly low 40 percent of GDP, Beijing announced its resolve to rebalance the economy toward a greater consumption share.”

In 2014, the household consumption to GDP ratio stood at 36.6%. Hence, the shift towards consumption driving economic growth has clearly not happened. The point being that the country is now addicted to the investment-exports driven growth model. In this scenario, every time there is a slowdown in economic growth, China resorts to the tried and tested investment led economic growth model. And the first step in this model is to get banks to lend more.

As Pettis writes: “The decision to upgrade is politically easy to make because each new venture generates local employment, rapid economic growth in the short term, and opportunities for fraud and what economists politely call rent-seeking behaviour, while costs are spread through the entire country through the banking system and over the many years during which the debt is repaid.”

This explains why Chinese banks lent 2.5 trillion yuan in January 2016, the most that they ever have. The trouble is that this round of economic expansion will lead to more excess capacity. And this will lead to a push towards higher exports and in the process hurt the global economy.

As Pettis writes: “China is not currently the engine of world growth. With its huge trade surplus, it actually extracts from the world more than its share of what is now the most valuable economic source in the world—demand. A rebalancing will mean a declining current account surplus and reduction of its excess claim on demand. This will be positive for the world.”

What Pettis basically means is that the Chinese household consumption to GDP ratio needs to go up i.e. the Chinese need to consume more of what they produce. But recent evidence clearly suggests that the Chinese government has no such plans and the investment-exports driven led economic growth strategy is likely to continue.

The column originally appeared in Vivek Kaul’s Diary on February 23, 2016

Piketty’s Tax Plan to Lower Inequality in India is Slightly Rickety

thomas piketty
This is something I wanted to write last week but could not given that Satyajit Das’s three part interview took up all the space.

The French economist Thomas Piketty was in Delhi recently to launch the Hindi edition of his book Capital in the Twenty First Century, among other things. During the course of an interview to The Hindu, Piketty said: “I hope the Indian elite will behave much more responsibly [in paying more taxes] than the western elite did in the 20th century.”

Piketty wants India’s elite to pay more tax to ensure that the income inequality in India comes down. In another interview to the Mint newspaper Piketty said: “India is a relatively high inequality country with a very strong legacy of extreme inequality for centuries between groups.”

Piketty feels that India’s income inequality is close to that of Brazil and South Africa with the top 10% making 50-60% of the total income. Piketty also feels that the income inequality in India may have gone up in the recent past. As he told The Times of India in an interview in November 2015: “The share of India’s national income going to top percentiles declined in the decades following independence, but has been rising since the 1980s-1990s, and is now back to pre-Independence levels, or maybe has surpassed them. The problem is that we do not really know, because it has become impossible to access income tax statistics.”

This income inequality can be addressed by taxing the rich more, feels Piketty.

[In fact, everyone does not agree with Piketty’s view of income inequality in India. Here is another view.

As Tim Harford writes in The Undercover Economist Strikes Back: “There simply isn’t enough money in India yet for it to be unequal.”

Harford explained what he meant by this in an interview to me where he said: “The World Bank economist Branko Milanovic has this idea of the “inequality possibility frontier”. Imagine an extremely poor subsistence society. Then imagine some class of plutocrats, who somehow confiscate wealth and spend it themselves. How much can they take? The answer is: not much if the society is to survive, because the poor cannot dip below the average income because the average income is barely enough to keep you alive. Now imagine a much richer society. This, in principle, could be far more unequal because the poor could still survive on a tiny fraction of the average income. Milanovic and co-authors were interested not only in how unequal a society is, but how unequal it is relative to how unequal it could possibly be. My point was that despite important gains over the past twenty years, India is still a very poor society. There’s a limit to how unequal it can get until it gets richer – which should make us worry about the inequality we do see.”]

Let’s get back to Piketty. Taxing the rich more was one of the main points that Piketty made in his book Capital in the Twenty First Century. As he writes: “The historical evidence suggests that with only 10-15 percent of national income in tax receipts, it is impossible or a state to fulfil much more than its traditional regalian responsibilities: after paying for a proper police force and judicial system, there is not much left to pay for education and health. Another possible choice is to pay everyone—police, judges, teachers, and nurses—poorly, in which case it is unlikely that any of these public services will work well.”

How do things look in India’s case? If we look at the annual budget of the government of India for 2015-2016, it’s tax revenue amounts to around 6.5% of the nominal gross domestic product (or national income). This is well below the limit that Piketty talks about.

It is very clear that the central government needs to collect more taxes than it currently is. There is no denying that. Piketty feels that it is time that India’s rich pay more taxes. He also suggests that India’s rich should be taxed more. It is important to realise here that the rich are not going to pay higher taxes on their own and hence, they need to be taxed more.

As Piketty told The Hindu: “India has zero wealth tax,” with the underlying message being that India needs to tax those who have wealth.

There are two issues here essentially: taxes and inequality. Let’s talk about inequality first. As Satyajit Das, an economic commentator and the author of The Age of Stagnation put it to me: “There are several sides to inequality. There is a moral and ethical dimension. There are arguments of fairness. There are arguments of proper incentives for achievement and skill. Each person will have a different view on that.”

But the economic argument is simpler. And what is that? As Das puts it: “First, empirical research suggests that an increase in income inequality by 1 Gini point decreases the annual growth in GDP per capita by around 0.2 percent.” Gini coefficient is a measurement of inequality where a gini coefficient of zero expresses perfect equality whereas a gini coefficient of one expresses maximal inequality.

To put it in simple English greater inequality of income leads to slower economic growth. And why is that? Das has an answer: “Higher income households have a lower marginal propensity to consume, spending a lower portion of each incremental dollar of income than those with lower incomes. US households earning US$35,000 have a marginal propensity to consume an amount from each additional dollar of income which is around three times that of a household with an income of US$200,000.”

Inequality comes with a huge social cost as well. As Das puts it: “Widening disparities in income level also impose direct costs such as life expectancy, crime levels, literacy and health. Rising inequality is associated with higher crime rates, particularly violent and property offences, poorer health, as well as family breakdowns and drug use. Unequal societies are affected by diseases of poverty, such as TB, malaria and gastrointestinal illnesses arising from poor nutrition and hygiene, inadequate housing, and a lack of
sanitation and access to timely health services.”

What all this clearly tells us is that income inequality is a problem. Is taxing the rich more really a solution to this?

It is worth asking here in the Indian context who are the rich when it comes to paying taxes? It is worth remembering here that in his February 2013 budget speech, the then finance minister P Chidambaram had estimated that India had only 42,800 people with a taxable income of Rs 1 crore or more.

As Piketty said in one of his interviews it is next to impossible to get hold of income statistics in India. Nevertheless, some progress has been made in the recent past. Akhilesh Tilotia of Kotak Institutional Equities, who is also the author of The Making of India, has done some excellent analysis on this front.

As Tilotia writes in a research note titled How Many Crorepatis in India released in early December 2015: “As e-filing of income taxes becomes the norm and the government gives out glimpses of data, it is now possible to estimate the number of entities in various slabs of incomes. Data suggests that over the four-year period of FY2011-14, the number of non-corporate entities reporting incomes > Rs10 million [or Rs 1 crore] has gone up 3 times to 63,589.” A non-corporate assesse includes “individuals, Hindu undivided families, partnerships, association of persons, etc.” This is around 0.5% of India’s population writes Tilotia.

What does this tell us? This tells us very clearly that very few of India’s rich actually pay taxes. So increasing the tax rates, as Piketty suggest, is really not a solution because the government will end up taxing the same set of people who are already paying a major part of India’s taxes.

Take the case of wealth tax. The finance minister Arun Jaitley abolished the wealth tax in the budget speech he made in February 2015. As Jaitley said during the course of his speech: “The total wealth tax collection in the country was Rs 1,008 crore in 2013-14.”

This basically means two things: a) Very few people in India bothered paying wealth tax. b) The income tax department was not in a position to get more people to pay wealth tax.

Also, it is worth remembering here that many Congress finance ministers since independence drove a substantial part of the Indian economy underground by having very high rates of income tax. The marginal rate of income tax even reached 97% at a certain point of time.

So a higher income tax rate is clearly not a solution to reduce income inequality in India. The solution is to bring more and more Indians who should be paying income tax, but do not, under the tax bracket. This means simplifying the income tax system. It also means making the income tax department more efficient through the use of information technology. And finally, it means reducing corruption in the department.

That is the solution to reducing income inequality in India. Higher tax rates are clearly not the way to go about it.

This column originally appeared in the Vivek Kaul’s Diary on February 1, 2016.

Satyajit Das Tells Us What is Really Happening in China

satyajit das

 

Dear Reader

This is the third and the concluding part of the interview with economic commentator and globally bestselling author Satyajit Das.

Das is an internationally respected commentator on financial markets and economics He is credited with predicting the current financial crisis. He has also featured 2010 Oscar-winning documentary Inside Job.

In this interview I speak to Das around his new book The Age of Stagnation—Why Perpetual Growth is Unattainable and the Global Economy is in Peril. Like his earlier books, Traders, Guns and Money and Extreme Money, this book is also a terrific read and a must for anyone who seriously wants to understand how things haven’t really changed in the aftermath of the financial crisis, and why the future continues to remain bleak.

In the third and the final part of this interview, Das talks about China and tells us what is really happening in there. He also tells us that “No one wants to believe that stagnation or collapse are the only two likely options”.

Happy Reading!
Vivek Kaul

On page 65 of your new book The Age of Stagnation you write: “Half of the investment in China since 2009 has been ineffective”. What makes you say that?

China’s growth especially after 2008/2009 was driven by a massive debt fund investment boom. A good proportion of this investment can be classified as ‘mal investment’; that is, revenues projects where revenues will be insufficient to cover the borrowing or generate adequate financial returns.

The bulk of investment has been by SOEs[state-owned enterprises] in government-backed infrastructure projects – the tiegong­ji (meaning “iron rooster”), a homonym for the Chinese words for rail, roads and airports. The Ministry for railways is planning investments of around $300 billion, adding 20,000 kilometres (“Kms”) of rail track to the existing network of 80,000 Kms. China’s rail network will become the second-longest in the world behind the US, overtaking India.

China is also having a love affair with the superfast train. Undeterred by accidents and the high cost, further expansion of the high speed rail network is under way. A new service between the southern cities of Guangzhou and Shenzhen travels at 380 kilometres per hour (KPH) nearly halving the travel time to 35 minutes. CSR Corp, China’s biggest train maker, has plans for a super train capable of 500 KPH.

What else is it doing?

China is constructing around 12,000 Kms of new expressways at a cost of over $100 billion. China road network of over 60,000 Kms of high-speed roads is only slightly less than the 75,000 Kms in the US. China is planning to expand the high-speed road network to 180,000 Kms even though China has only around 40 million passenger vehicles compared to 230 million in the US.

There is a spate of new airports and expansions of capacity at existing facilities. Jiaxing in eastern Zhejiang province is converting a military landing strip into a commercial airport at a cost of around $50 million. The town is only one hour’s drive on brand new expressways from three of China’s busiest international airports in Shanghai and Hangzhou. There are also plans for a high-speed rail line connecting Shanghai and Hangzhou.

In Hunan, local authorities tore down portions of a modern flyway and used the stimulus funding to rebuild it. Stories of ghost cities, such as the empty newly-built city of Ordos, Zhengzhou New District, Dantu and the orange area to the north-east of the Xinyang, abound. There are ghost shopping malls in many cities.

Could you tell us more?

Based on estimates from electricity meter readings, there are more than 60 million empty apartments and houses in urban areas of China. Many of the properties were purchased by people speculating on rising property prices.

The projects have driven a sharp rise in demand for materials like steel and concrete. China now produces more steel than the next eight largest producers combined. China now produces more cement than the rest of the world. But this over-investment in non-productive, low return projects will ultimately reduce growth.

For the rest of the world, the investment boom fed demand for commodities and machinery in the short run. Ultimately, it will create problems in two ways: firstly, many companies globally have over-invested in capacity based on anticipated Chinese demand that may not eventuate; and second, dumping of Chinese overcapacity on global markets will feed disinflationary pressures.

In your chapter on Brics you write that it would take decades for China to absorb the excess capacity that it has created over the years. Can you elaborate a little on that?

Sino-philes attribute the excess capacity to the collapse of global demand. They assume that global demand will rebound strongly increasing the returns from these investments.

Sino-philes also argue that the investments in infrastructure will produce long term economic benefits and returns from increased productivity. They point to the fact that few investment programs of social infrastructure are profitable. They point to the mid-19th century boom in investment in railways in Western countries, which generated economic benefits, but few made an adequate financial return with many going bankrupt. They also argue that China lacks necessary infrastructure.

 So what is the real issue?

The real issue is whether the specific projects are appropriate. China has six of the world’s ten longest bridges and the world’s fastest train. But 40% of villages lack paved road providing access to the nearest market town. High-speed rail lines in China may increase social return, improving the quality of life for the average Chinese if they are wealthy enough to afford to use them. But the financial return on capital invested in these projects will be low.

While many of these large projects are appealing to politicians and demagogues proclaiming superiority of Chinese technical proficiency, investment in improving ordinary train lines, rural roads, safety and more flexible pricing structures may have yielded higher economic benefits.

There are several concerns now about this economic model.

And which are?

First, analysts, such as Pivot Capital Management, argue that the efficiency of Chinese investment has fallen. One measure is the incremental capital-output ratio (“ICOR”), calculated as annual investment divided by the annual increase in GDP. China’s ICOR has more than doubled since the 1980s and 1990s, reflecting the marginal nature of new investment. Harvard University’s Dwight Perkins of Harvard argues that China’s ICOR rose from 3.7 in the 1990s to 4.25 in the 2000s. Other researchers suggest that it now takes around $6-8 of debt to create $1 of Chinese GDP, up from around $1-2 around 20 years ago. In the US, it took $4-5 debt to create $1 of GDP just before the GFC. This is consistent with declining investment returns.

Second, increased level of debt and the often uneconomic projects financed has led to increasing concern as to whether the debt can be serviced.

How much is that an issue?

A 2012 Bank of International Settlements (“BIS”) research paper on national debt servicing ratios (“DSR”) found that a measure above 20-25% frequently indicated heightened risk of a financial crisis. Analysts estimate that China’s DSR may be around 30% of GDP (around 11% goes to interest payment and the rest to repaying principal), which is dangerously high.

The debt problems are compounded by other factors. A large portion of the debt is secured over land and property, whose values are dependent on the continued supply of credit and strong economic growth.

A high proportion of debt is short term, with around 50% of loans being for 1 year, requiring refinancing at the start of each year. As few Chinese borrowers have sufficient operating cash flow to repay loans, new borrowings are needed to service old ones.

Around one-third of new debt is used to repay or extend the maturity of existing debt. With a significant proportion of new debt needed to merely repay existing debt the amount of borrowing needs to constantly increase to maintain economic growth.

China observers now worry about whether the high absolute levels of debt, rapid increases in borrowing, increasing credit intensity, servicing problems and the quality or value of underlying collateral are likely to result in a financial and economic crisis – a Minsky Moment.

On slightly different note what do you see the impact of the depreciation of the Chinese yuan on global growth?

Most nations now have adopted a similar set of policies to deal with problems of low economic growth, unemployment and overhangs of high levels of government and consumer debt. In a shift to economic isolationism, all nations want to maximise their share of limited economic growth and shift the burden of financial adjustment onto others. Manipulation of currencies as well as overt and covert trade restrictions, procurement policies favouring national suppliers, preferential financing and industry assistance policies are part of this process.

A weaker currency boosts exports, driven by cheaper prices. Stronger export led growth and lower unemployment assists in reducing trade and budget deficits.

With Europe and Japan still actively trying to weaken their currencies and the US owing its recovery in part to this policy, China will be forced to join the global currency wars.

And what are the Chinese hoping here?

First, they will be hoping that it will provide a needed boost to slowing growth through exports.

Second, it will help with the policy of internal rebalancing away from investment to consumption by offsetting the loss of competitiveness through higher wage costs.

But there are risks. Retaliation in the form of competitive QE programs and intervention is possible. In addition, China risks triggering higher inflation and also uncontrolled capital flight which would expose its financial system vulnerabilities. The country’s foreign currency reserves (already down some US$700 billion to around US$3,300 billion) would fall sharply, reducing its financial flexibility.

You seem to remain unconvinced about the world having come out of the aftermath of the financial crisis and you write that a risk of a sudden collapse is ever-present. Why do you say that?

There are three possible scenarios.

In the first, the strategies in place lead to a strong recovery. The US leads the way. Europe improves as the required internal transfers and rebalancing takes place with Germany accepting debt mutualisation to preserve the Euro. Abe-nomics revives the Japanese economy. China makes a successful transition from debt financed investment to consumption. A financial crisis in China from the real-estate bubble, stock price falls and massive industrial overcapacity is avoided. Other emerging economies stabilise and recover as overdue structural reforms are made. Growth and rising inflation reduce the debt burden. Monetary policy is normalised gradually. Higher tax revenues improve government finances. There is even strong international policy co-ordination, avoiding destructive economic wars between nations.

Oh that is clearly a lot to expect…

Such an outcome is unlikely. The fact that current policies have not led to a recovery after 6 years suggests that they are ineffective.

The second scenario is a managed depression, a Japan like prolonged stagnation.

Economic growth remains weak and volatile. Inflation remains low. Debt levels continue to remain high or rise. The problems become chronic requiring constant intervention in the form of fiscal stimulus and accommodative monetary policy, low rates and periodic QE programs to avoid deterioration.

Financial repression becomes a constant with nations transferring wealth from savers to borrowers to manage the economy. Competition for growth and markets drives beggar-thy-neighbour policies, resulting in slowdowns in trade and capital movements.

Authorities may be able to use policy instruments to maintain an uneasy equilibrium for a period of time. But it will prove unsustainable in the long run. Ultimately, a major correction will become unavoidable, as confidence in policy makers ability to control the situation diminishes.

And what is the final scenario?

The final scenario is the mother of all crashes. Financial system failures occur as a significant number of sovereigns, corporate and households are unable to service their debt. Defaults trigger problems in the banking system which leads to a major liquidity contraction, which in turn feeds back into real economic activity. Falls in employment, consumption and investment drive a severe contraction. The problems are global with developed and emerging markets affected.

The downturn is exacerbated by the limited capacity of policy makers to respond. Weakened public finances and policy options (QE and low rates) exhausted in fighting the last crisis limit the ability of governments to respond to a new crisis. Emerging markets are now unlikely to be a source of demand due to their problems. Geo-political stresses are higher than in 2007/ 2008.

Unsurprisingly, no one wants to believe that the stagnation or collapse are the only two likely options. Hubris, as humorist PJ O’Rourke noted is one of the great renewable resources.

Concluded…

The column originally appeared on the Vivek Kaul Diary on January 29, 2016

“The toxic effects of policies have now created conditions for a new financial crisis”

satyajit dasDear Reader

This is the second part of the interview with economic commentator and globally best-selling author Satyajit Das.

Das is an internationally respected commentator on financial markets and economics He is credited with predicting the current financial crisis. He has also featured 2010 Oscar-winning documentary Inside Job.

I would like to state here that I actually understood how financial derivatives caused a major part of the current financial crisis only after reading Extreme Money authored by Das. Until then my understand was shaky.

His first general book Traders, Guns and Money is a master class on derivatives, given that Das’s technical tomes on financial derivatives running into thousands of pages, remain a standard reference on Wall Street.

In this interview I speak to Das around his new book The Age of Stagnation—Why Perpetual Growth is Unattainable and the Global Economy is in Peril. Like his earlier books this book is also a terrific read and a must for anyone who seriously wants to understand how things haven’t really changed in the aftermath of the financial crisis, and why the future continues to remain bleak.

This is the second part of a three-part interview. The concluding part will appear tomorrow.

Happy Reading!
Vivek Kaul

 

Do you see all the debt that has been accumulated by governments over the years, ever being repaid? How do you see this playing out?

Interestingly, total public and private debt in major economies increased not decreased since 2008. The Table below sets out the changes in debt levels in the global economy:

Global Stock of Debt Outstanding

(US$ Trillion, Constant 2013 Exchange Rates)

 200020072014Compound Annual

Growth Rate (%)

Type of Debt   2000–20072007-2014
Household1933408.5%2.8%
Corporate2638565.7%5.9%
Government2233585.8%9.3%
Financial2037459.4%2.9%
Total Debt871421997.3%5.3%
Total Debt (as % of GDP)246%269%286%  

Source: Richard Dobbs, Susan Lund, Jonathan Woetzel and Mina Mutafchieva (2015) Debt and (not much) deleveraging, McKinsey Global Institute: 2

Total debt has continued to grow at a slower rate than before the GFC but remains well above the corresponding rate of economic growth. Higher public borrowing has largely offset debt reductions by businesses and households.

Could you tell us a little more about that?

Between 2007 and 2014, the ratio of public sector debt to GDP in advanced economies increased by 35 percent of GDP, compared to an increase of 3 percent between 2000 and 2007. The increase in government debt reflected the effects of the GFC. It was designed to support the financial system. Government spending sought to boost demand and growth. The increase in debt predictably was highest in the worst affected countries, such as the UK, Greece, Spain, Portugal and Ireland.

Given slow growth, low inflation rates and the balance between tax revenues and expenditure and inflation rates, government debt to GDP ratios are forecast to rise for the foreseeable future in the US, Japan and many European countries. In many countries, government debt has reached levels which are unsustainable. It is unclear how these highly indebted economies will reduce the level of government debt.

Why do you say that?

Debt can only be reduced through strong economic growth. Many economies in the world today have debt-to-GDP ratios of 300 percent. If the average interest rate is 3 percent, then to meet interest payments the economy would need to grow at 9 percent (300 percent [debt] times 3 percent [interest rate]), an unlikely nominal rate of expansion.

The alternative is debt forgiveness, defaults or inflation. But all these steps, other than growth are not without consequences. Savings designed to finance future needs, such as retirement, are lost. This in turn results in additional claims on the state to cover the shortfall or reduce future expenditure which crimps economic activity. Significant write-downs on sovereign debt would trigger major crises for banks and pension funds. The resulting losses to savers would trigger a sharp contraction of economic activity. National governments would need to step in to inject capital into banks to maintain the payment and financial system’s integrity.

In One Lesson: The Shortest & Surest Way to Understand Basic Economics, Henry Hazlitt summarised the problem: “Everything we get, outside of the free gifts of nature, must in some way be paid for. The world is full of so-called economists who in turn are full of schemes for getting something for nothing. They tell us that the government can spend and spend without taxing at all; that it can continue to pile up debt without ever paying it off, because ‘we owe it to ourselves’.” It is useful to remember that.

One of the things you write is that the stock markets have decoupled from the real economy. Why do you say that?

Equity prices now do not correlate to fundamental economic factors, such as nominal gross domestic product or economic growth, or, sometimes, earnings.

Writing in the Financial Times, James W. Paulsen, chief investment strategist at Wells Capital Management, advised Investors not to be too concerned about slower earnings growth. Mr. Paulsen forecast a 2,600 target for the S&P 500, or an annualised five-year return in excess of 10 per cent, including dividends. He warned investors about “becoming too myopically focused on these mainstream issues lest [they] miss what could be the second confidence-driven bull market of the post-war era”. Given that shares represent claims on the earnings derived from the real economy, this is puzzling.

It indeed is…

Veteran Legg Mason fund manager Bill Miller once observed that: “The common view [is] that the weak stock market reflects a weakening economy. But we think the converse is more likely: the weak stock market is causing the economy to weaken”.  Equity analyst Laszlo Birinyi supported this view of causality: “The relationship between the stock market and the economy is tangential, not causal”. It is not clear why the equity market should drive the real economy, rather than the other way around.

There may be some possible explanations for the divergence between the real economy and equity prices. First, share values are increasingly affected by opaque accounting and what one observer termed the ‘expectations machine’; that is, manipulating and beating expectations rather than absolute performance criteria. Then there are higher levels of corporate activity such as share repurchases and mergers and acquisitions which affect values.

Second, equity markets have become instruments of economic policy, as policy makers try to increase asset values to generate higher consumption driven by the ‘wealth effect’. Monetary measures, such as zero interest rate policy and quantitative easing, distort equity prices. Dividend yields that are higher than bond interest rates now drive valuations. Future corporate earnings are discounted at artificially low rates.

Any other reasons?

Third, the increased role of high frequency trading (“HFT”) has changed equity markets. HFT constitutes up to 70% of trading volume in some markets. The average holding period of HFT trading is around 10 seconds. The investment horizon of portfolio investors has also shortened. In 1940, the average investment period was 7 years. In the 1960s, it was 5 years. In the 1980s, it fell to 2 years. Today, it is around 7 months. The shift from investing for the long run has fundamentally changed the nature of equities, with momentum trading a larger factor.

Fourth, the increasing effect of HFT has increased volatility and the risk of large short term price changes, such as that caused by the ‘flash crash’, discouraging some investors.

Fifth, alternative sources of risk capital, the high cost of a stock market listing, particularly increasing compliance costs, increased public disclosure and scrutiny of activities including management remuneration as well as a shift to different forms of business ownership, such as private equity, have changed the nature of equity market. New capital raisings are increasingly viewed with scepticism as private investors or insiders seek to realise accreted gains, subtly changing the function of the market.

Sixth, financialisation may facilitate market manipulation, whereby the corrosive impact of insider trading and market abuse erodes investor confidence.

Financial instruments, such as shares and their derivatives, are intended as claims on real businesses. Over time, trading in the claims themselves have become more rewarding, leading to a disproportionate increase in the level of financial rather than business activity.

You write: “politicians and central bankers gambled that growth and increased inflation would over time correct the problems”. But things did not turn out as they expected. What went wrong there?

Policy makers assumed that the Great Recession of 2007/8 was a cyclical downturn not a structural change. George Soros got it absolutely right: “[It] resembles other crises that have occurred since the end of the Second World War at intervals ranging from four to 10 years…there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years.”

And what happened because of the mis-diagnosis?

Given the mis-diagnosis, policy maker reacted with their usual responses: fiscal stimulus and looser monetary policy (low rate and then QE). This was never going to work as the debt overhang meant private economic activity did not recover to pre-crisis levels. Low rates did not actually encourage borrowing and spending.

The GFC left a legacy of large debts, forcing households to reduce spending so as to repay borrowings, with low-income households reducing spending by twice as much as richer households. The debt overhang and caution about borrowing has reduced the impact of low interest rates. Households are unwilling or unable to increase debt. The fall in house prices in some countries, and the resulting decline in household wealth, has made borrowing difficult; lending against home equity has decreased. Banks have also tightened lending standards, in response to loan losses. These factors mean that a consumption-based economic recovery is unlikely without income redistribution to households with a higher propensity to spend, or finding a new source of demand. The lack of demand has resulted in weak investment, also slowing growth.

As result, the global economy is locked into a path of low growth and low inflation tending to disinflation or deflation. That would be fine if it were not for the high levels of debt which will spiral out of control in such conditions.

So what was really needed?

What was needed were major structural changes: dealing with the excessive debt, dealing with global imbalances, addressing the unfunded entitlements which affect public finances and rebalancing between the real and financial economy. Then, there were other issues like demographics, slowing productivity and innovation as well as the problems of inequality, environment and scarce resources. But no government has had the political courage to tackle these issues to the degree necessary.

So what they did was make a bad situation worse by increasing debt. The toxic effects of the policies have now created the conditions for a new financial crisis.

In essence, they tried to do the wrong things better rather than do the right things badly.

To be continued…

Disclosure: Satyajit Das wrote the foreword to my book Easy Money: Evolution of Money from Robinson Crusoe to the First World War

The interview originally appeared in the Vivek Kaul Diary on January 28, 2016

“The build-up of debt over last 25 years has been excessive, beyond repayment capacity.”

satyajit das
Dear Reader,

This is a special edition of the Vivek Kaul Diary. This is the first time I am interviewing someone for the Diary. In this interview I speak to Satyajit Das, an internationally respected commentator on financial markets, credited with predicting the current financial crisis. He has also featured 2010 Oscar-winning documentary Inside Job.

I would like to say here that personally I have learnt a lot from reading what Das has written over the years. His two books Traders, Guns and Money and Extreme Money have been a master class on derivatives as well as how they caused the financial crisis.

Honestly, if you were to read only one book on the financial crisis, it has to be Extreme Money.

In this interview I speak to Das around his new book The Age of Stagnation—Why Perpetual Growth is Unattainable and the Global Economy is in Peril. Like his earlier books this book is also a terrific read and a must for anyone who seriously wants to understand how things haven’t really changed in the aftermath of the financial crisis, and why the future continues to remain bleak.

This is the first part of a three-part interview. The other two parts will appear over the next two days.

Happy Reading!
Vivek Kaul

I would like to start with a clichéd question. Why did very few economists and experts see the economic crisis coming?

I think Richard Breeden, a former chairman of the SEC, probably identified the reason best: “It’s probably a better question for a psychologist. There’s a group dynamic…nobody likes to be the person who sends everybody home from the party when they’re having a good time.”

People rarely see what is front of them because of a mixture of ideology, biases and incentive structures. Proponents of markets are never going to concede that the mechanisms had failed or were even capable of failure.

Most economists and experts are guilty of ‘groupthink’. People with similar backgrounds and largely insulated from outside opinions tend to make decisions without critically testing, analysing and evaluating ideas or evidence. They collective rationalise, convinced about the inherent morality of their views, their unanimity and invulnerability. They also hold stereotyped views of outsiders and do not tolerate dissent. People work in neat silos and don’t look outside their narrow specialisation.

People employed by financial organisations are deeply compromised, forced to propagate the party line. Upton Sinclair was correct in noting that “it is difficult to get a man to understand something when his salary depends on his not understanding it”.

What made you feel that a crisis was on the way?

My only advantage is that I am not beholden to anybody or any organisation. I don’t have strong ideologies. My interest is in facts and trying to understand them. I am extremely pragmatic, adhering to what works or doesn’t. It is a luxury.

But you also need to be lucky, especially on timing of events.

One of the first things you write in your book is “future generations may have lower living standards than their parents”. This I would guess is one of the key points of the book as well. Why do you say this?

Future economic historians may come to regard the last two centuries and especially the post WW2 period, as an exception in terms of large improvements in livings standards.

Ultimately, prosperity depends on economic growth. If growth is slower and more volatile in the future then future generations will have lower living standards. The reasons are fairly simple.

First, much of the recent prosperity was built on debt funded growth which is not repeatable. An unknown portion of this debt will have to written off either explicitly (default/ restructuring) or implicitly (through reduction in purchasing power through inflation or financial repression). A large amount of wealth will be wiped out.

Second, environmental damage will restrict future growth. This will be through acceptance of lower levels of economic activity as the world restricts the use of fossil fuels which is unlikely. The alternative will be lower growth as a result of the catastrophic costs of climate change, in terms of damage, dislocation or shortages of essential goods and services.

Can you give us an example?

For example, India will have to accept the problems of water shortages and lower food production as well as having to deal with the forced displacement of a large part of the population of Bangladesh. There are also ancillary costs like health costs from air, water and soil pollution.

Third, resources like water, food and energy will get scarcer and therefore more expensive.

Fourth, our model for dealing with these issues is simply to extend and pretend and kick the problem further down the road. In effect, past and present generations will have enjoyed the benefit but the costs will be borne by future generation, reducing their living standards.

The problem will manifest itself at an individual level in three ways. A large part of future generations will find employment, particularly secure and well-paid jobs, more difficult to obtain. A commentator in Greece argued, with black humour, that the government could save money on education because it was unnecessary to prepare people for jobs that did not exist.

Purchasing houses and large capital goods may become harder. Also, the idea of a finite working life followed by retirement will become a luxury for most. People will have to work till they die or are unable to work.

We see all these trends already in many societies.

Much of the world’s population (probably 5-6 billion of the 7 billion on earth) are already in the position that I have described. It is the other 1-2 billion who aspired to a better life for themselves and their children who will have to adjust their expectations, which have been set too high.

You write that “we may never know the real cost of the financial crisis”. Why do you say that?

Costs of crisis are always complex. There are measureable losses in the value of financial assets like equities, property and loan write-offs. There are structural effects which economist refers to as hysteresis; that is a single disturbance which affects the course of the economy. An example is the delayed effects of unemployment. As unemployment increases, more people adjust to a lower standard of living. There is reduction of potential output. There are complex questions about what period we measure losses over.

The 2007/2008 financial crisis illustrates this point. Large financial institutions throughout the world collapsed or suffered near fatal losses. Values of houses and financial assets, like shares, fell sharply. In the real economy, there was a sharp downturn in economic activity, unemployment often for prolonged periods, housing foreclosures and evictions and failures of businesses.

What is the biggest number you have come across with regard to the cost of the financial crisis?

In 2009, the IMF estimated the cost to that stage at around US$12 trillion, equivalent to around 20 percent of the entire globe’s annual economic output. In 2013, Tyler Atkinson, David Luttrell and Harvey Rosenblum, three economists at the Federal Reserve Bank of Dallas, tentatively quantified the loss to the US economy as between US$6 and US$14 trillion, around US$19,000 to US$45,000 per person. Under certain assumptions, they found that the loss could be higher – US$25 trillion or over 150% of GDP, almost US$80,000 per American. No one may ever know the full cost.

There are huge indirect costs like lost human potential and suffering, which we do not measure. A diary entry at the time of the Great Depression in Siri Hustvedt novel Sorrows of An American reads: “A depression entails more than economic hardship, more than making do with less. That may be the least of it. People with pride find themselves beset by misfortunes they did not create; yet because of this pride, they still feel a pervasive sense of failure… People become powerless.” We don’t measure that.

On page 34 you write: “everybody, it seemed, agreed with Oscar Wilde that living within one’s income merely showed a lack of imagination”. Why do you say that? Isn’t it a very fierce indictment of the Western World?

Developed economies are now 60-70% consumption.

If we look at the post war period then you see a persistent pattern of promoting consumption. Initially, it was about meeting unsatisfied needs. Over time, it shifted to manufacturing demand though a variety of strategies ranging from advertising to planned obsolescence.

Consumption driven economies require you to keep consuming to drive economic activity to provide employment to give you income to buy more things you don’t really need. There is a piece of graffiti art by Bansky which I have always liked. It reads: “join a hilarious adventure of a lifestyle – work, buy, consume, die”.

In Das Kapital, Karl Marx identified this inherent tendency of capitalism towards overproduction. Theologian Reinhold Niebuhr saw society as enslaved to its productive process, reversing the normal process of producing to satisfy consumption needs. Economists dismiss overproduction, arguing that supply creates its own demand (known as Say’s Law). They view consumer needs as essentially unlimited, with people wanting more and better goods.

It may be an indictment of Western economic system.  My objective was not judgemental. It was to describe what was happening. In essence, economic growth and prosperity were by-products of consumption, unsustainable resource exploitation and serious environmental damage. It would be fair to say in recent decades nobody was took the advice of 19th century philosopher John Stuart Mill “[seeking] happiness by limiting … desires, rather than in attempting to satisfy them”.

There is a great belief among economists that borrowing leads to economic growth. How true is that? Has the impact of debt on growth come down over the years?

There is nothing inherently good or bad about debt. It can be used to drive economic growth, allowing immediate consumption or investment against the promise of paying back the borrowing in the future. Spending that would have taken place normally over a period of years is accelerated because of the availability of debt.

The use of debt can be beneficial, where the economic activity generated is sufficient to repay the borrowing with interest. This requires borrowing to finance assets or investments which generate income or value to repay principal and interest. A significant proportion of current debt does not meet this test.

Only (around) 15-20% of total financial flows went into investment projects with the remaining 80-85% being used to finance existing corporate assets, real estate or unsecured personal finance to facilitate consumption. Borrowings were frequently used to finance pre-existing assets where anticipated price rises were to be the source of repayment.

Under these conditions, a slowdown in the ability to borrow ever increasing amounts can lead to a sharp fall in asset prices to levels below the outstanding debt creating repayment difficulties. This is precisely what happened in 2007/2008 and is likely to happen again, sooner than people think.

The build-up of debt over the last quarter of a century has been excessive, beyond repayment capacity.

Could you elaborate on that?

In the lead up to 2007/2008, there was a rapid build-up in debt in developed economies. Between 2000 and 2009 total global credit grew from US$57 trillion to US$109 trillion, equating to a growth of 7.5% per annum, around double the growth in economic activity. In many countries, debt reached three to four times Gross Domestic Product (“GDP”), levels not normally reached other than in wartime (i.e. 1914-1918 and 1939-1945) when the result was losses for creditors of the losing states.

The other problem is that you need to borrow ever increasing amounts to both repay existing borrowing but also to maintain economic growth. By 2007/2008, the US needed $4-$5 of debt to create $1 of economic growth, compared to an additional $1-$2 of debt per additional $1 of GDP in the 1950s.

To be continued…

Disclosure: Satyajit Das wrote the foreword to my book Easy Money: Evolution of Money from Robinson Crusoe to the First World War