From Michael Robert's Blog
August 7, 2011 by michael robertsGlobal financial markets are in panic. Stock prices have fallen by as much as 10% in a couple of weeks. The big institutions have rushed to put their money and that of their clients into ‘safe-haven’ assets. The Swiss franc has appreciated against other currencies by as much 15% in a month, forcing the Swiss National Bank to sell its own currency and buy more dollars and euros in a vain attempt to weaken its currency. Swiss exporters are being squeezed to death by the high value of their ‘safe’ currency. The gold price has reached an all-time nominal high at $1680/oz, although it is still below its peak in the early 1980s if inflation is taken into account.
The value of these financial assets has fallen for two reasons: the so-called sovereign debt crisis and the apparent slowdown of growth in the major capitalist economies. The fear of another financial collapse along the lines of the meltdown after the bankruptcy of the US investment bank Lehman Brothers in September 2008 and the possibility of a drop back into the depths of the Great Recession – a double-dip – has spooked markets.
I dealt with the growth issue in my last post (see The Great Recession and the recovery: who is right? 1 August 2011). So let’s look at the debt crisis. The sovereign debt crisis is now a double-headed dragon. On one head has been the continuing worry that several governments in the Eurozone would no longer be able to pay back the banks, pension funds and other institutions the money lent to them for the purchase of government bonds, the main form of borrowing by governments. Starting with the Greeks (see my posts), fear of insolvency spread to Ireland (see post) and eventually to Portugal. The other Eurozone governments agreed (reluctantly) to provide government funds to ‘bail out’ these governments so they could pay back the banks.
As I have explained, this just means more taxpayers money is being used to bail out the banks (see my post, Paying for Europe’s banking mess, 16 March 2011). These Eurozone governments ran up huge annual deficits on their budgets and saw their overall debt levels rocket because they had to recapitalise their banks after the financial collapse in 2008-9 and also to give support to the drop in incomes and employment during the Great Recession that ensued. Indeed, the deficits on the government books were not because of ‘profligate’ spending by governments (except on ‘defence’) but because of a massive drop in tax revenues as financial institutions and other corporations made losses not profits and households lost incomes and jobs.
The latest chapter in the euro debt crisis turned on Greece again. The first bailout was just not enough to convince the financial markets (i.e. the banks and other big institutions) that they would get their money back. They refused to lend to Greece except at loan shark interest rates of 16-25% a year – a rate so high that the Greeks would never be able to pay it back. After tortuous negotiations, general strikes and riots, the Greek leaders agreed to another horrendous round of spending cuts, tax rises, job losses and income reductions in return for more money. But this new bailout did not calm markets for long. Part of the Greek deal was that the banks would have to accept a small reduction in the full repayment they were entitled to. The principle of these Euro governments defaulting on their debt was thus established.
That was enough to worry the banks that they may not get the full repayment on the money they were owed by Ireland, Portugal and even worse, Spain or Italy. If Italy could not pay its debts, then the whole Eurozone financial system was in jeopardy. The Italian government’s cost of borrowing rose to over 6%, still way lower than the Greeks, but now above that of Spain and because Italy has a very large government debt at 120% of GDP, if the cost of borrowing stayed close to 7% for several years, Italy would never get its debt down. So we have headed for a ‘tipping point’ in the euro debt crisis. Either the other Eurozone governments would have to commit to funding Italy or the euro might break up.
This is the litmus test for the Germans and French, the two countries that created the euro. The German conservative leaders fear backlash from their electorate if they agree to stump billions of euros to help Italy and Spain. So far they have agreed to be the major supporter of an emergency Eurozone fund called the European Financial Stability Facility (EFSF). But the EFSF has only €440bn of funds and it has committed about one-quarter of this to bail out Ireland, Portugal and Greece (twice). And the cost of helping Italy and Spain so that they do not need to borrow from the banks for, say the next three years, while imposing more spending cuts and tax rises to convince markets, would be closer to €1.3trn, or four times what is currently available.
As I write, the Germans, the Dutch and others arguing with the French, Italians and Spanish about whether speedily to increase the level of EFSF funding or not. In the meantime, such was the panic in markets last week, that the European Central Bank (ECB) was forced to agree (again reluctantly) to say it would start to buy government bonds if the banks would not. Thus it was hoped that markets would calm down if they saw the ECB was ‘intervening’. But no. The ECB refused to say whether it would buy Italian bonds, which was what markets wanted to hear. As I write, the ECB is considering some token move to do so.
If all this was not bad enough for confidence in capitalist financial markets, a new head on the dragon appeared. The US debt ceiling saga took a further nasty turn. Again, after tortuous negotiations, America’s politicians had finally agreed to a rise in the fixed ceiling on what the US government could have in debt. The impasse was only broken when President Obama and the Democrats capitulated to the demands of the Republicans in imposing only spending cuts and no tax rises to reduce the US budget deficit that is set to reach 10% of GDP this year. Obama did this so he could push the issue of who is to pay for reducing the deficit back until after the next presidential election.
But the issue was not killed because it is not clear if it won't reemerge when the special committee set up to look at further cuts meets in November. It may be in deadlock again. And the real tipping point came when one of the three large credit rating agencies, Standard and Poors (S&P) decided to ‘downgrade’ the quality of US government debt from the top triple-A rating to AA+, the first time US government debt had not been rated the safest in the world.
This is a moment of history. The US capitalist economy has been the dominant power in the world since the end of the second world war, with the biggest economy, the largest financial sector, the largest armed forces and the most powerful influence in all the international institutions, from the UN, the IMF, the World Bank etc. But from the 1970s, US capitalism started to decline. This was a relative decline. The US economy got bigger and so did its financial sector and its armed might. But the dollar lost its status for being as good as gold when Nixon took the US dollar off the gold standard (the dollar’s value was no longer fixed to the price of gold). New economic rivals appeared: Europe, Japan and of course China. Ironically, after the apparent victory of capitalism in the cold war over stalinism, with the collapse of the Soviet Union and the Eastern European states, the relative decline of the US accelerated. US capitalism started running trade deficits with japan, China and Europe and the Arab states. It financed huge imports of oil and other goods from these countries by borrowing. The US government and corporations offered bonds for the holders of the dollars around the world to buy. US capitalism went into debt with the rest of the world. Now nearly half of the bonds that have just been downgraded by the S&P agency are held by the likes of China, Japan and other foreign banks and governments. And they are not happy at having their assets reduced in potential value.
The US government has attacked the S&P for its decision. They hint at the failure of the credit agencies to downgrade all that mortgage debt that was supposed to be triple A and yet eventually brought the US financial system to its knees in the credit crunch of 2007-8. How can the S&P be trusted when they failed the nation back then? Or so the argument goes. Of course, the credit agencies were corrupt and in the pockets of the banks that owned them. And they are doing the banks’ bidding again. It did not help when they got their figures wrong in estimating the likely level of government debt that they decided to downgrade.
But even if they got their figures wrong, the reality is that US government debt has rocketed to record levels and there is little sign that it will be got under control. The US is still running a 10% of GDP headline budget deficit this year. The Euro area’s budget deficit will be around 4.2% of GDP in 2011. On an underlying (cyclically-adjusted) basis, the US budget deficit figure is 8.7% of GDP, compared to the Euro area’s -2.5% figure. US gross government debt will eclipse 100% of GDP this year, higher than in the Euro area. US net government debt (that’s after any financial assets are added in) at 75% compares to 60% in the Euro area. The US net debt/GDP ratio has risen by 40% points of GDP since 2001, Europe’s is up just 12% points over the same period.
In order to bring its gross public sector debt burden back to it pre-crisis level of 60% of GDP within a 15-year timeframe, the US needs to implement a cumulative 18% of GDP improvement in its primary budget balance. This is more than Ireland, Greece or Portugal and compares to a EMU-wide figure of 5.6% of GDP required swing. So the US ‘debt crisis’ is way worse than the Eurozone’s. It’s just that so many other capitalist countries depend on dollars to do their business, keep their savings and make investments, that the US has been able to avoid a crisis up to now.
And this brings us to the key question. Why does the level of government debt matter? Keynesians like Paul Krugman say it does not matter. When Republican vice-president Dick Cheney in the last Republican administration, said that budget “deficits don’t matter”, the Keynesians would agree. For the Keynesians, if governments run an annual deficit on the spending and revenue and thus increase their borrowing each year, it does not matter because it will be financed by corporations and households saving more and the economic identities will balanced. Indeed, if corporations and households save more, or too much, they could cause a slump in the economy because investment and consumption will decline. So government deficits can be necessary, not bad. Indeed, it is necessary to get out of any slump like the Great Depression or the Great Recession.
Krugman dismisses the S&P downgrade as a fuss about nothing. After all, if the US government finds it has to pay a little more interest on its borrowings, it really is neither here nor there. “Amid all the debt hysteria, it’s worth taking a look at the actual arithmetic here — because what this arithmetic says is that the size of the deficit in the next year or two hardly matters for the US fiscal position — and in fact the size over the next decade is barely significant. Start with interest rates. What matters for debt sustainability is the real interest rate, since what matters is keeping real debt, not nominal debt, from growing. (World War II debt never got paid off, it just eroded in real terms to the point where it was trivial). As of yesterday, the US government could lock in 30-year bonds at a real interest rate of 1.25%. That means that a trillion dollars in extra debt would mean $12.5 billion a year in additional real interest payments. Meanwhile, the CBO estimates potential real GDP in 2021 at about $18 trillion in 2005 dollars, or around $19 trillion in 2011 dollars. Put these together, and they say that an extra trillion in borrowing adds something like 0.07% of GDP in future debt service costs. Yes, that zero belongs there. The $4 trillion S&P said it needed to see clocks in at less than 0.3% of GDP. These are not, to say the least, make or break numbers.”
Indeed, if the US and other capitalist economies were just to invest and consume a bit more, economic growth will be sufficient to absorb this government debt burden and restore ‘confidence’. The Keynesians thus dismiss the debt crisis as so much ideological hokum designed to allow the Republicans or the Tories in Britain to privatise the economy and cut the state sector.
But are we to dismiss this crisis that exercises the minds of the world’s politicians and strategists over this holiday weekend as some ‘storm in a teacup’? It seems an awful lot of noise for nothing. The answer is that deficits and debt do matter to capitalism. If governments start running deficits, they have to be paid for either by raising taxes or cutting back on spending; or by borrowing (and borrowing more as the interest cost on the borrowing rises). Yes, governments could just print money to pay for their debts (they have that unique power), but that would eventually mean devaluing the currency used to pay for things. It is something that the US government has done with its external deficit. As a result, the buying value of the dollar has fallen over the last 30 years by over 25%. And who has lost? The owners of dollars, namely the economies of Europe, Japan, China and the Middle East. Similarly, if governments print money to pay for their debts at home, they will drive up inflation and devalue wages and savings. So the losers are average households and most important, corporate cash. The worry for capitalism is that government debt can be serviced only by increased interest rates that eat into the profits of corporations. Even worse, governments will not pay back monies lent to them. And if a government goes on spending without recourse, the whole state sector starts to usurp the role of the capitalist sector and eat into its profitability.
That is why government debt levels matter. ‘Excessive debt’ means government debt that is so high that it eats into profitability through higher taxes on business, less subsidies to business, higher inflation of costs and higher interest rates for borrowing across the board. So government spending, Keynesian-style, can only be a substitute for failing private investment and consumption for a short while. Ultimately it is a burden on capitalism not its saviour. That is why it must be reduced.
Sure, at a time when businesses and households are paying down their debts (deleveraging) after the excesses of the credit boom, if governments must deleverage too, then that threatens a new recession (see my post, Deleveraging and the economic recovery, 11 July 2011). But the alternative of continued government borrowing is lower profitability and a weakening of the capitalist system of production. The Austerians don’t want that and favour another recession as a necessary cleansing of the capitalist system; the Keynesians favour more government spending to save the capitalist system. Neither pose its removal.The value of these financial assets has fallen for two reasons: the so-called sovereign debt crisis and the apparent slowdown of growth in the major capitalist economies. The fear of another financial collapse along the lines of the meltdown after the bankruptcy of the US investment bank Lehman Brothers in September 2008 and the possibility of a drop back into the depths of the Great Recession – a double-dip – has spooked markets.
I dealt with the growth issue in my last post (see The Great Recession and the recovery: who is right? 1 August 2011). So let’s look at the debt crisis. The sovereign debt crisis is now a double-headed dragon. On one head has been the continuing worry that several governments in the Eurozone would no longer be able to pay back the banks, pension funds and other institutions the money lent to them for the purchase of government bonds, the main form of borrowing by governments. Starting with the Greeks (see my posts), fear of insolvency spread to Ireland (see post) and eventually to Portugal. The other Eurozone governments agreed (reluctantly) to provide government funds to ‘bail out’ these governments so they could pay back the banks.
As I have explained, this just means more taxpayers money is being used to bail out the banks (see my post, Paying for Europe’s banking mess, 16 March 2011). These Eurozone governments ran up huge annual deficits on their budgets and saw their overall debt levels rocket because they had to recapitalise their banks after the financial collapse in 2008-9 and also to give support to the drop in incomes and employment during the Great Recession that ensued. Indeed, the deficits on the government books were not because of ‘profligate’ spending by governments (except on ‘defence’) but because of a massive drop in tax revenues as financial institutions and other corporations made losses not profits and households lost incomes and jobs.
The latest chapter in the euro debt crisis turned on Greece again. The first bailout was just not enough to convince the financial markets (i.e. the banks and other big institutions) that they would get their money back. They refused to lend to Greece except at loan shark interest rates of 16-25% a year – a rate so high that the Greeks would never be able to pay it back. After tortuous negotiations, general strikes and riots, the Greek leaders agreed to another horrendous round of spending cuts, tax rises, job losses and income reductions in return for more money. But this new bailout did not calm markets for long. Part of the Greek deal was that the banks would have to accept a small reduction in the full repayment they were entitled to. The principle of these Euro governments defaulting on their debt was thus established.
That was enough to worry the banks that they may not get the full repayment on the money they were owed by Ireland, Portugal and even worse, Spain or Italy. If Italy could not pay its debts, then the whole Eurozone financial system was in jeopardy. The Italian government’s cost of borrowing rose to over 6%, still way lower than the Greeks, but now above that of Spain and because Italy has a very large government debt at 120% of GDP, if the cost of borrowing stayed close to 7% for several years, Italy would never get its debt down. So we have headed for a ‘tipping point’ in the euro debt crisis. Either the other Eurozone governments would have to commit to funding Italy or the euro might break up.
This is the litmus test for the Germans and French, the two countries that created the euro. The German conservative leaders fear backlash from their electorate if they agree to stump billions of euros to help Italy and Spain. So far they have agreed to be the major supporter of an emergency Eurozone fund called the European Financial Stability Facility (EFSF). But the EFSF has only €440bn of funds and it has committed about one-quarter of this to bail out Ireland, Portugal and Greece (twice). And the cost of helping Italy and Spain so that they do not need to borrow from the banks for, say the next three years, while imposing more spending cuts and tax rises to convince markets, would be closer to €1.3trn, or four times what is currently available.
As I write, the Germans, the Dutch and others arguing with the French, Italians and Spanish about whether speedily to increase the level of EFSF funding or not. In the meantime, such was the panic in markets last week, that the European Central Bank (ECB) was forced to agree (again reluctantly) to say it would start to buy government bonds if the banks would not. Thus it was hoped that markets would calm down if they saw the ECB was ‘intervening’. But no. The ECB refused to say whether it would buy Italian bonds, which was what markets wanted to hear. As I write, the ECB is considering some token move to do so.
If all this was not bad enough for confidence in capitalist financial markets, a new head on the dragon appeared. The US debt ceiling saga took a further nasty turn. Again, after tortuous negotiations, America’s politicians had finally agreed to a rise in the fixed ceiling on what the US government could have in debt. The impasse was only broken when President Obama and the Democrats capitulated to the demands of the Republicans in imposing only spending cuts and no tax rises to reduce the US budget deficit that is set to reach 10% of GDP this year. Obama did this so he could push the issue of who is to pay for reducing the deficit back until after the next presidential election.
But the issue was not killed because it is not clear if it won't reemerge when the special committee set up to look at further cuts meets in November. It may be in deadlock again. And the real tipping point came when one of the three large credit rating agencies, Standard and Poors (S&P) decided to ‘downgrade’ the quality of US government debt from the top triple-A rating to AA+, the first time US government debt had not been rated the safest in the world.
This is a moment of history. The US capitalist economy has been the dominant power in the world since the end of the second world war, with the biggest economy, the largest financial sector, the largest armed forces and the most powerful influence in all the international institutions, from the UN, the IMF, the World Bank etc. But from the 1970s, US capitalism started to decline. This was a relative decline. The US economy got bigger and so did its financial sector and its armed might. But the dollar lost its status for being as good as gold when Nixon took the US dollar off the gold standard (the dollar’s value was no longer fixed to the price of gold). New economic rivals appeared: Europe, Japan and of course China. Ironically, after the apparent victory of capitalism in the cold war over stalinism, with the collapse of the Soviet Union and the Eastern European states, the relative decline of the US accelerated. US capitalism started running trade deficits with japan, China and Europe and the Arab states. It financed huge imports of oil and other goods from these countries by borrowing. The US government and corporations offered bonds for the holders of the dollars around the world to buy. US capitalism went into debt with the rest of the world. Now nearly half of the bonds that have just been downgraded by the S&P agency are held by the likes of China, Japan and other foreign banks and governments. And they are not happy at having their assets reduced in potential value.
The US government has attacked the S&P for its decision. They hint at the failure of the credit agencies to downgrade all that mortgage debt that was supposed to be triple A and yet eventually brought the US financial system to its knees in the credit crunch of 2007-8. How can the S&P be trusted when they failed the nation back then? Or so the argument goes. Of course, the credit agencies were corrupt and in the pockets of the banks that owned them. And they are doing the banks’ bidding again. It did not help when they got their figures wrong in estimating the likely level of government debt that they decided to downgrade.
But even if they got their figures wrong, the reality is that US government debt has rocketed to record levels and there is little sign that it will be got under control. The US is still running a 10% of GDP headline budget deficit this year. The Euro area’s budget deficit will be around 4.2% of GDP in 2011. On an underlying (cyclically-adjusted) basis, the US budget deficit figure is 8.7% of GDP, compared to the Euro area’s -2.5% figure. US gross government debt will eclipse 100% of GDP this year, higher than in the Euro area. US net government debt (that’s after any financial assets are added in) at 75% compares to 60% in the Euro area. The US net debt/GDP ratio has risen by 40% points of GDP since 2001, Europe’s is up just 12% points over the same period.
In order to bring its gross public sector debt burden back to it pre-crisis level of 60% of GDP within a 15-year timeframe, the US needs to implement a cumulative 18% of GDP improvement in its primary budget balance. This is more than Ireland, Greece or Portugal and compares to a EMU-wide figure of 5.6% of GDP required swing. So the US ‘debt crisis’ is way worse than the Eurozone’s. It’s just that so many other capitalist countries depend on dollars to do their business, keep their savings and make investments, that the US has been able to avoid a crisis up to now.
And this brings us to the key question. Why does the level of government debt matter? Keynesians like Paul Krugman say it does not matter. When Republican vice-president Dick Cheney in the last Republican administration, said that budget “deficits don’t matter”, the Keynesians would agree. For the Keynesians, if governments run an annual deficit on the spending and revenue and thus increase their borrowing each year, it does not matter because it will be financed by corporations and households saving more and the economic identities will balanced. Indeed, if corporations and households save more, or too much, they could cause a slump in the economy because investment and consumption will decline. So government deficits can be necessary, not bad. Indeed, it is necessary to get out of any slump like the Great Depression or the Great Recession.
Krugman dismisses the S&P downgrade as a fuss about nothing. After all, if the US government finds it has to pay a little more interest on its borrowings, it really is neither here nor there. “Amid all the debt hysteria, it’s worth taking a look at the actual arithmetic here — because what this arithmetic says is that the size of the deficit in the next year or two hardly matters for the US fiscal position — and in fact the size over the next decade is barely significant. Start with interest rates. What matters for debt sustainability is the real interest rate, since what matters is keeping real debt, not nominal debt, from growing. (World War II debt never got paid off, it just eroded in real terms to the point where it was trivial). As of yesterday, the US government could lock in 30-year bonds at a real interest rate of 1.25%. That means that a trillion dollars in extra debt would mean $12.5 billion a year in additional real interest payments. Meanwhile, the CBO estimates potential real GDP in 2021 at about $18 trillion in 2005 dollars, or around $19 trillion in 2011 dollars. Put these together, and they say that an extra trillion in borrowing adds something like 0.07% of GDP in future debt service costs. Yes, that zero belongs there. The $4 trillion S&P said it needed to see clocks in at less than 0.3% of GDP. These are not, to say the least, make or break numbers.”
Indeed, if the US and other capitalist economies were just to invest and consume a bit more, economic growth will be sufficient to absorb this government debt burden and restore ‘confidence’. The Keynesians thus dismiss the debt crisis as so much ideological hokum designed to allow the Republicans or the Tories in Britain to privatise the economy and cut the state sector.
But are we to dismiss this crisis that exercises the minds of the world’s politicians and strategists over this holiday weekend as some ‘storm in a teacup’? It seems an awful lot of noise for nothing. The answer is that deficits and debt do matter to capitalism. If governments start running deficits, they have to be paid for either by raising taxes or cutting back on spending; or by borrowing (and borrowing more as the interest cost on the borrowing rises). Yes, governments could just print money to pay for their debts (they have that unique power), but that would eventually mean devaluing the currency used to pay for things. It is something that the US government has done with its external deficit. As a result, the buying value of the dollar has fallen over the last 30 years by over 25%. And who has lost? The owners of dollars, namely the economies of Europe, Japan, China and the Middle East. Similarly, if governments print money to pay for their debts at home, they will drive up inflation and devalue wages and savings. So the losers are average households and most important, corporate cash. The worry for capitalism is that government debt can be serviced only by increased interest rates that eat into the profits of corporations. Even worse, governments will not pay back monies lent to them. And if a government goes on spending without recourse, the whole state sector starts to usurp the role of the capitalist sector and eat into its profitability.
That is why government debt levels matter. ‘Excessive debt’ means government debt that is so high that it eats into profitability through higher taxes on business, less subsidies to business, higher inflation of costs and higher interest rates for borrowing across the board. So government spending, Keynesian-style, can only be a substitute for failing private investment and consumption for a short while. Ultimately it is a burden on capitalism not its saviour. That is why it must be reduced.
How will the debt crisis pan out? Most likely, the European leaders will find some way of funding more of their government debt while increasing the burden of taxation and unemployment on their electorates. It will be the same in the US. The result will be lower economic growth for several years ahead than capitalism has achieved in the last 50 years. But this ‘middling way’ won’t be enough and eventually falling profitability will exert its gravitational pull on these capitalist economies and we shall have another deep economic recession. The euro may not survive that.
There is an alternative. The politicians in Europe and America may be at a loss and divided on what to do. But the people of Europe and America are not. We are told that the American people are split down the middle between those who support the policies of the Republican ‘tea party’ wing and those who support higher taxes and more Medicare. Gillian Tett, the US editor of the Financial Times argued this week that polarisation of politics in the US was getting worse. “Short of an external shock, or internal conceptual revolution, it is hard to see the polarisation going away – or not while economic inequality is growing, too. “ But is it true that the American people are really divided down the middle on what they think? According to a NY Times poll last week, 40% of those asked looked on the crazy Tea party unfavourably after their antics over the debt ceiling issue, up from 26%, while Obama’s popularity held up. It appears that the majority of Americans do not want to destroy their remaining public services and welfare safety net, such as it is, on the altar of ‘small government’ and the ‘free market’.
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